MEMORANDUM OF DISCUSSION

A meeting of the Federal Open Market Committee was held

in the offices of the Board of Governors of the Federal Reserve

System in Washington, D.C., on Tuesday, July 16, 1974, at 9:30 a.m.

PRESENT: Mr. Mr. Mr. Mr. Mr. Mr. Mr. Mr. Mr.

Mr. Mr.

Burns, Chairman Hayes, Vice Chairman Black Bucher Clay Holland Kimbrel Mitchell Sheehan Wallich Winn

Messrs. Coldwell, Mayo,and Morris, Alternate Members of the Federal Open Market Committee

Messrs. Eastburn, Francis, and Balles, Presidents of the Federal Reserve Banks of Philadelphia, St. Louis, and San Francisco, respectively

Mr. Broida, Secretary Mr. Altmann, Deputy Secretary Mr. Bernard, Assistant Secretary Mr. O'Connell, General Counsel Mr. Partee, Senior Economist Mr. Axilrod, Economist (Domestic Finance) Messrs. Brandt, Davis, Doll, Gramley, Hocter,

Pierce, and Reynolds, Associate Economists

Mr. Holmes, Manager, System Open Market Account

Mr. Coombs, Special Manager, System Open Market Account

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Mr. Coyne, Assistant to the Board of Governors

Mr. Wonnacott, Associate Director, Division of International Finance, Board of Governors

Mr. Williams, Adviser, Division of Research and Statistics, Board of Governors

Mr. Wendel, Assistant Adviser, Division of Research and Statistics, Board of Governors

Miss Pruitt, Economist, Open Market Secretariat, Board of Governors

Mrs. Ferrell, Open Market Secretariat Assistant, Board of Governors

Mr. Van Nice, First Vice President, Federal Reserve Bank of Minneapolis

Messrs. Eisenmenger, Boehne, Scheld, and Sims, Senior Vice Presidents, Federal Reserve Banks of Boston, Philadelphia, Chicago, and San Francisco, respectively

Messrs. Snellings, Jordan, and Green, Vice Presidents, Federal Reserve Banks of Richmond, St. Louis, and Dallas, respectively

Mr. Kareken, Economic Adviser, Federal Reserve Bank of Minneapolis

Ms. Tschinkel, Manager, Securities Department, Federal Reserve Bank of New York

By unanimous vote, the minutes of actions taken at the meeting of the Federal Open Market Committee held on June 18, 1974, were approved.

The memorandum of discussion for the meeting of the Federal Open Market Committee held on June 18, 1974, was accepted.

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Before this meeting there had been distributed to the members

of the Committee a report from the Special Manager of the System

Open Market Account on foreign exchange market conditions and on

Open Market Account and Treasury operations in foreign currencies

for the period June 18 through July 10, 1974, and a supplemental

report covering the period July 11 through 15, 1974. Copies of

these reports have been placed in the files of the Committee.

In supplementation of the written reports, Mr. Coombs made

the following statement:

The exchange markets are probably beset with more uncertainties and apprehension right now than at any time since the war. As the floating exchange rate system gradually emerged after 1970, the initial result was to open up immense and fairly predictable profit possibilities to foreign exchange traders throughout the world as Government spokesmen both here and abroad sought either to talk up or to talk down rates on their currencies. In this speculative

environment, we saw a sort of hothouse growth of

trading in the foreign exchange and Euro-dollar

markets. Traders all over the world became increasingly reckless in the search for quick profits.

Since last summer, however, predicting exchange rate movements has become a highly risky affair, as market developments have been dominated by major uncertainties as to the differential impact of the oil crisis, abrupt shifts in relative rates of inflation, and varied Government responses to inflationary developments. While Government policy in most major countries has become increasingly concerned during the past year about the inflationary impact of exchange depreciation and has tended to resist such depreciation, official intervention in most countries has still not been on a sufficiently large scale to prevent a rollercoaster pattern of exchange rates; during the past year

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almost every major currency has been subject at one time or another to a serious depreciation. I think we are now at a stage where the risks inherent in the floating rate system have become fairly obvious.

In this new and harsher climate, the first casualties have already begun to appear in the form of the Franklin National and Herstatt episodes, and it would not be surprising if similar situations abroad were uncovered over weeks and months to come. The closure of the Herstatt bank during the business day has had a particularly severe effect on confidence, since it pointed up to bank management all over the world that a spot foreign exchange contract could easily involve a major credit risk. Immediately following the Herstatt episode, the major banks both here and abroad instituted severe new trading procedures designed to limit their exposure, not only by sharply reducing the maximum size of transactions but also by refusing to deal with any but the very best names.

Over the past 2 weeks, we understand, the New York banks have relaxed their standards so as to provide reasonable accommodation for most of the U.S. regional banks with whom they had been dealing. The impact on Europe and Japan remains much more severe, however, with many if not most small and mediumsized banks still finding it very difficult to get the major U.S. and European banks to accept their names. Yet many of the small and medium-sized European banks probably have large forward exchange books outstanding and many have been heavily involved in Euro-dollar trading as well. In the Euro-dollar market, for example, we now see the emergence of a multi-tier rate structure; yesterday, some Japanese banks were paying 16 per cent on 3-month money, and European banks in the Herstatt class are probably encountering even greater difficulty. More generally, we see a severe contraction in the volume of trading in the spot exchange market. Commercial customers probably can still buy and sell what they need to cover their spot requirements in foreign exchange, but the forward market has almost completely dried up and in due course this could have serious effects on the flow of international trade and investment.

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During the past 3 weeks, we felt that we were confronted with an emergency situation in the exchange markets in which sharp rate movements could have further aggravated the crisis of confidence. The German Federal Bank has shared this view and both we and they have accordingly moved somewhat more promptly than before to restrain the amplitude of daily exchange rate swings. Other European central banks seem to be operating in similar fashion with useful stabilizing effects upon the whole exchange rate structure.

I do not mean to suggest any basic shift in dayto-day operating policies; I believe it would be appropriate to yield ground if there are strong pressures emerging in the exchange market. However, I think we have to be a bit more careful about letting these rates move very far from day to day.

Mr. Morris asked whether Mr. Coombs thought the Desk had

sufficient leeway to deal with critical situations that might arise.

Mr. Coombs replied that his only concern in that regard

related to the problem that would arise if the System wanted to

draw on swap lines other than that with the German Federal Bank.

As the members knew, the arrangement in place with the Germans would

leave them to bear the full risk on any drawings they made, but called

for them to share equally with the Federal Reserve any profits or

losses on System drawings. A similar arrangement applied to the

Belgian and Dutch lines. With respect to the other swap lines, how

ever, the provisions for risk-bearing were not spelled out and would

have to be decided upon if either party desired to draw. It might

well become desirable soon to draw on the French swap line for inter

vention purposes--the franc had been strong recently and could become

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stronger--but he thought it unlikely that the French would be willing

to accept the asymmetrical arrangement in place with the Germans.

Nor was it likely that the Japanese would accept that sort of arrange

ment. Sooner or later, in his judgment, it would be necessary to con

sider introducing symmetrical provisions with respect to risk-bearing

in the various swap lines, although it was conceivable that the

Germans would be content to have the present asymmetrical arrange

ment remain in effect.

By unanimous vote, the System open market transactions in foreign currencies during the period June 18 through July 15, 1974, were approved, ratified, and confirmed.

Mr. Coombs then noted that a number of System swap drawings

dating back to 1971 would mature for the twelfth time soon. They

included 6 drawings on the National Bank of Belgium, totaling $230

million, which matured in the period from August 2 through 14; and

two Swiss franc drawings--one of $600 million on the Bank for

International Settlements and one of $371.2 million on the Swiss

National Bank--which matured on August 14 and 15, respectively.

There was some possibility of repaying some or all of those draw

ings before maturity, but since that was not assured he would

recommend that the Committee authorize their renewal if necessary.

Since the swap lines in question had been in continuous use for

more than one year, express authorization was required for renewal

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under the provisions of paragraph 1(D) of the Authorization for

Foreign Currency Operations.

By unanimous vote, renewal for further periods of 3 months of System drawings on the National Bank of Belgium, the Swiss National Bank, and the Bank for International Settlements, maturing in the period August 2-15, 1974, was authorized.

Chairman Burns then noted that Committee members had

received a draft of a letter to the Secretary of the Treasury con

cerning possible use by Italy of the Federal Reserve swap line.1/

He invited Mr. Wallich to comment on the background for the proposed

letter.

Mr. Wallich remarked that Secretary Simon would return from

his current trip to the Middle East--where he was visiting Egypt,

Israel, Kuwait, and Saudi Arabia--via France, England, and Germany,

where he expected among other things to have conversations about

the balance of payments problems of Italy. The Italians, as was

well known, were facing a very difficult situation; under the best

of circumstances, they would require large-scale international

assistance unless oil prices were reduced substantially. In his con

versations, Secretary Simon was expected to take the position that

1/ The draft letter in question was transmitted to the Committee with an explanatory memorandum from Chairman Burns on July 15, 1974. Copies of the memorandum and attachment have been placed in the Committee's files.

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the main responsibility for assistance to Italy lay with Germany,

the richest of the nearby countries; that the U.S. share in an

assistance package might be roughly proportionate to its share as

a source of total Italian imports; and that if the Italians approached

the United States for assistance, it would be suggested that they

consult Germany first.

Mr. Wallich observed that possibilities with respect to a

package of assistance had been discussed in several recent meetings

of U.S. Government officials in which he, along with other System

people, had participated. He had been surprised to discover in

those meetings that representatives of other agencies considered

the System's swap line with the Bank of Italy to be an appropriate

mechanism for extending a large proportion of the credits that might

be advanced by the United States. Federal Reserve representatives

had repeatedly stressed that the System's swap lines were intended

to be short-term facilities for dealing with forces that were

expected to be temporary and reversible, not as a source of medium

term credits of the kind Italy needed to meet its oil problem.

Such statements, however, had had only a limited effect; in sub

sequent versions of the assistance package the System's proposed

contribution reappeared, although somewhat reduced.

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The firm tone of the draft letter reflected that experience,

Mr. Wallich observed. After stressing that swap drawings were

available only for short-term purposes and not to meet medium- or

long-term needs, the letter suggested that the Bank of Italy might

make drawings in two $250 million tranches, each for 3 months but

subject to renewals up to a year. The first tranche would be avail

able freely but the second would be subject to certain conditions,

illustrated by a reference to the condition that Italy obtain com

mensurate amounts on comparable terms from other parties. The

letter went on to suggest that for any further drawings the Committee

would expect firm take-out provisions, such as a pledge of the pro

ceeds of prospective IMF drawings or of gold collateral.

In general, Mr. Wallich remarked, drawings by the Bank of

Italy to meet its present problems would represent a use of the

swap network different from the uses made in the past. At the

same time, it should be noted that the System had agreed earlier

this year to increase the Italian swap line from $2 billion to $3

billion; after such an action, it would be difficult to turn down

a proposed drawing the first time funds were needed. Moreover,

the U.S. Government unfortunately was ill-prepared to deal with

the Italian crisis. The Treasury proposed to rely on the scat

tered sources of funds already available, including the Exchange

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Stabilization Fund and the System's swap line, on the grounds

that it would not be useful to recommend Congressional legislation-

a course which he considered to be basically the correct one. Unless

oil prices came down, other countries were likely to find themselves

in situations like that facing Italy at present. Indeed, the problem

of financing oil imports was likely to be a major problem in inter

national finance.

Mr. Wallich said he thought that, while the Federal Reserve

probably could not avoid participating in a package of assistance

to Italy, it would be wise to limit its participation to a minimum.

The role the System had played in the 1968 credit package to Britain

offered some distant precedent for participating; according to the

record, the Committee had agreed to extend credits to Britain despite

some uneasiness about prospects for repayment. That precedent was

only partial, however, because Britain's problems had arisen from

a capital flow situation and thus were basically reversible. For

tunately, the British drawings were repaid quite promptly. While he

might be wrong, he thought the repayment prospects in connection with

drawings under the first two tranches now proposed for Italy were

not as good as those in the British case in 1968. For any amounts

beyond the first $500 million, protection would be provided by the

firm take-out provisions called for in the draft letter. In that

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connection, the pledge of gold collateral might be considered less

satisfactory than the pledge of proceeds from prospective IMF draw

ings, since it was not clear how the System could realize on gold

collateral.

Mr. Eastburn asked whether the discussions at the inter

agency meetings to which Mr. Wallich had referred in effect con

stituted contingency planning for the various possible emergencies

that might arise, and whether an effort had been made to foresee

the likely sequence of developments beyond the Italian situation.

Mr. Wallich replied that the inter-agency discussions con

cerning a possible package for Italy certainly constituted contingency

planning. In his opinion the inter-agency discussion had anticipated

even by more than needed at this time; during the course of a long

conversation he had had with the Italian representative at the July

Basle meeting, the latter had chosen not to take advantage of the

opportunity to mention Italy's distress and its need for funds, On

the contrary, he had noted that the Bank of Italy was beginning to

take in foreign exchange--partly for seasonal reasons related to the

summer tourist season, but partly as a consequence of the monetary

measures recently taken by the Italian authorities and the expecta

tion that the Government's fiscal measures would prove effective.

To his knowledge, Mr. Wallich continued, no extended consid

eration had been given by U.S. officials to where, beyond Italy,

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international assistance might be needed. It would be counter

productive, in his view, for the United States to suggest that it

was prepared to offer assistance to other countries encountering

problems in financing oil imports. That would reduce pressures on

those countries to improve their own positions, and it would reduce

pressures on the oil exporters to lower their prices. Moreover, it

would reduce the likelihood that the bulk of any necessary financ

ing assistance would come from the source he considered most appro

priate: the oil exporting countries. Contingency planning should

be directed at developing methods other than credits from the

United States for financing oil imports.

Mr. Hayes said he had understood on a visit to the Bank of

Italy about 3 weeks ago that the Bank preferred to avoid external

borrowing for a time while the Government was developing the needed

internal measures. He asked whether that consideration still appeared

to be relevant.

Mr. Wallich responded affirmatively.

Mr. Holland asked for the Special Manager's view about the

likely impact on the attitudes of the System's other swap partners

of Committee willingness to have the Bank of Italy draw on the swap

line to help deal with its current problems.

In reply, Mr. Coombs said it seemed likely that bargaining

would take place soon of the kind that had often occurred in the

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past in connection with packages of international credit assistance.

He was strongly in favor of the general tone of the draft letter,

including the statement in the final paragraph that decisions con

cerning the System's swap arrangements were in the province of the

Committee. The letter did suggest that the Committee would be will

ing to have the Italians draw $500 million on the swap line, a point

Secretary Simon might well mention in his European conversations.

In his (Mr. Coombs') view, it would be important to maximize the

effect of such an undertaking; he would want to know, for example,

what such key central banks as those of Germany, Switzerland, and

Canada might be prepared to contribute to an assistance package. Past

experience suggested that a better package would be developed if

U.S. officials took an active part in the negotiations rather than

relying on the authorities of some other country, such as Germany,

to do the main negotiating.

Chairman Burns observed that Italy needed medium- or long

term money, whereas the Federal Reserve--if it held to the tradi

tional view of its swap network, as he thought it should--could

provide only short-term funds. The two $250 million tranches men

tioned in the draft letter to Secretary Simon would represent only

a minor part of a broad credit package. The State Department was

likely to urge the System to go further; indeed, that process was

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already under way. His consistent reply had been that, since the

Italians needed longer-term credits and the System could extend

only short-term credits, main reliance would have to be placed on

other sources of funds. He had indicated that the System would

play as constructive a role as possible in helping to arrange a

package of medium-term credits for Italy, and that it also would

help in financing the Italians for a brief period. He hoped the

System would be able to hold to that position. He could envisage

circumstances in which the Committee would want to bend, but he

hoped it would not bend quickly or easily. In any case, he would

find it easier to deal with the Departments of State and Treasury

if the Committee were to support the draft letter before it.

Mr. Mitchell said he had received the impression from

Mr. Wallich's comments that prospects for repayment of Italian

swap drawings, particularly under the first tranche, might be

relatively low. He was not sure Mr. Wallich intended to leave

such an impression; in any case, he (Mr. Mitchell) thought that

short-term credits should not be granted unless there was a high

probability that they would be repaid, perhaps with the proceeds

of medium- or long-term loans.

The Chairman remarked that Mr. Wallich's approach was

probably realistic. If the Bank of Italy were to draw $500 million

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on the swap line, the System might spell out its terms and condi

tions with utmost precision on the occasion of the original drawing

and of each subsequent renewal--and still find, when a year had

elapsed, that the Italians were unable to repay. There was a hazy

zone in that respect from which he saw no escape.

Mr. Hayes concurred in the Chairman's comment. He added

that direct lending by oil-producing countries to Italy was being

considered and discussed. While he could not say whether such

loans would eventuate, they were a possibility.

Chairman Burns said he personally doubted that the oil pro

ducers would make direct loans to Italy even at very high rates of

interest. However, they might make such loans indirectly, through

the IMF or some other international agency.

Mr. Holland said he thought one modification of the text of

the draft letter would make it more expressive of the Committee's

intent. Specifically, he would delete the word "freely" in the

statement that "It would be appropriate for the Bank of Italy to

draw, say, $250 million freely..." and to indicate by appropriate

language that drawings on the first two tranches would be avail

able in anticipation of longer-term financing to be obtained by

the Italians.

There was general agreement with Mr. Holland's suggestion.

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Mr. Coldwell observed that it might be desirable at some

point for the Committee to consider whether it wanted to shift

the basis for its swap network from a nominally short-term facility

to one which contemplated longer-term credits. Such a discussion

seemed warranted by the fact that some drawings, both by the System

and by other parties, had proved to be of a longer-term nature.

If the shift were made it would, of course, be appropriate to

inform the Congress.

Chairman Burns expressed the view that such a shift would

launch the Committee down a highly dangerous road. If the Federal

Reserve were to abandon the principle that the swap lines were

available only to meet short-term needs, there would be a natural

tendency for other agencies of Government to look to the System,

rather than to the Congress, for the resources to deal with a broad

variety of international financial and political problems. If the

System were to provide those resources it would, in effect, be

substituting its own authority for that of the Congress. A decisive

case could then be made in support of the charge that the System

was using Federal moneys without regard to the intent of the

Congress.

Mr. Wallich said it would be inappropriate on economic

grounds as well for the Federal Reserve to extend long-term credits

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to assist other countries in financing their oil deficits. The

funds to finance those deficits were available in the surpluses

of the oil-exporting countries, and they needed only to be properly

channeled. The United States had already made its contribution in

the form of enlarged payments for imported oil, and it should

minimize further contributions--either through money creation by

the central bank or through Congressional appropriations.

Mr. Mitchell commented that today's discussion would make

a highly disturbing record.

Chairman Burns remarked in that connection that there

apparently had been some carelessness recently with regard to

the confidentiality of the Committee's deliberations. He could

not stress too strongly that those deliberations were not to be

discussed with unauthorized persons.

Mr. Mitchell commented that his concern was not limited

to the question of confidentiality. In an environment in which

private lenders and oil-producing countries were refusing to lend

to Italy, he would be disturbed by a record which indicated that

the Committee had agreed to extend $250 million or $500 million

to Italy without any real assurance of repayment. Specifically,

he was disturbed by Mr. Wallich's earlier comments on that point.

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Before he concurred in the extension of such credits--and he

hoped to be able to do so--he would want assurances that there

was a strong probability of ultimate repayment. He would not be

greatly disturbed if the credits ran on for more than a year,

particularly since the Federal Reserve itself had been the bene

ficiary of such roll-overs in a number of cases. But a high risk

of ultimate nonpayment was a different matter.

Chairman Burns said he had not understood Mr. Wallich to

suggest ultimate nonpayment.

Mr. Wallich observed that he had meant only to suggest

that the drawings might not be repaid within one year. His purpose

had been to express properly the risks that every credit operation,

and this one in particular, carried. Every effort would be made to

protect the first tranche along the lines implied by Mr. Holland's

suggested modification of the draft letter, so that the operation

should be banker-like in character.

Mr. Holland said he hoped the proposed letter would be

permitted to stand on its own in any discussion of the Committee's

attitude toward credits to the Bank of Italy. In particular, he

hoped no suggestion would be made that the letter should be inter

preted against the background of the System's long-standing draw

ings on the Swiss and Belgian swap lines.

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The Chairman concurred in Mr. Holland's observation.

A proposed letter from Chairman Burns to the Secretary of the Treasury, concerning possible use by the Bank of Italy of its swap line with the Federal Reserve, was approved.

Secretary's note: The text of the letter in question, which was transmitted later on the day of this meeting, is appended to this memorandum as Attachment A.

Secretary's note: A report by Mr. Wallich on the July Governors' meeting in Basle, which was distributed to the members during the course of this meeting, is appended to this memorandum as Attachment B. A report by Ms. Junz on the June meeting of the Economic Policy Committee of the OECD is appended as Attachment C.

Chairman Burns then called for the staff report on the

domestic economic and financial situation, supplementing the

written reports that had been distributed prior to the meeting.

Copies of the written reports have been placed in the files of

the Committee.

Mr. Gramley presented the following statement:

Coincident business indicators suggest that there has not been much change during the past month in the generally sluggish performance of the economy described by Mr. Partee at the last Committee meeting. The industrial production figures for June were disappointing. Total industrial output did not increase further--auto assemblies stabilized and production of business equipment actually declined a little. There appears to be no major category of industrial activity showing a significant expansive thrust at this time.

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The employment figures for June were a mixed bag. Total employment and the civilian labor force rose, and the unemployment rate remained unchanged. The nonfarm payroll series, however, showed a small decline on the month, mainly reflecting reductions in manufacturing and construction, due partly to strikes. Employment in these two industries is now about 275,000 below the level of last November, and the length of the workweek in manufacturing also has fallen off by half an hour since then.

Part of the recent sluggishness of economic activity can be attributed to continuing shortages-particularly of steel and coal. The steel shortage-and related scarcities in the machinery industries-are probably instrumental in holding back output of business capital equipment. Unfilled orders in the nondefense capital goods industries are enormous-almost 40 per cent above a year ago--and still rising. And revised figures becoming available since the last Committee meeting on new orders for capital goods are a little stronger than earlier estimates.

The dominant factors affecting current indicators of economic activity, however, are demand weaknesses in consumer markets and the recession in housing. In real terms, retail sales fell a little further in June-continuing the generally downward trend since the spring of 1973. Consumers are still quite pessimistic--although

apparently less gloomy than they were at the height of the oil shortage earlier this year--and real spendable incomes of workers, though up a little in May, are nearly 5 per cent below a year ago.

Housing starts and permits in May were both down sharply, and starts may have dropped further in June. Judging from comments in the red book,1/ the residen

tial construction industry is in a serious plight almost everywhere. The multi-family market appears

to be experiencing greater difficulties than the single

family market--probably because of the severe cutback in the availability and the high cost of construction financing attributable in part to the problems of the

1/ The report, "Current Economic Comment by District," prepared

for the Committee by the staff.

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REIT's. There is, however, at least one piece of favorable news about the housing market. Sales of new single-family houses by merchant builders are rising; in May, they were 24 per cent above the rate in the fourth quarter of last year, though still 14 per cent below a year earlier.

On the price side, the news continues to be most disappointing. The rise in industrial commodity prices has yet to show signs of abatement, and prices of farm products--after declining steeply during the spring months--have been rising again since the June pricing date for the wholesale price index. The wage rate acceleration of the past couple of months is particularly disturbing. We are estimating another increase in unit labor costs during the second quarter of around 12 per cent, annual rate, as productivity apparently fell further while wage rate increases were accelerating.

In our staff projection of GNP, we have had to raise once again our estimate of the projected rate of price increase between now and mid-1975. We have also lowered once again our projection of real growth, to an average rate a little below 1 per cent for the next four quarters, mainly because of the deteriorating outlook for residential building. This is quite a weak picture, but there are several reasons for believing that real expansion may prove to be even less than we now foresee.

First, our econometric model continues to project a much weaker economy than we have in our judgmental model, and we have learned from experience that the model's forecasts are worth considering. Second, our present green book 1/ GNP projection makes no allowance for the effects on savings flows of Citicorp-type security issues, and there could be serious adverse effectsonhousing coming from this source. Third, we have made no allowance, either, for significant downward adjustments in spending that might develop because of the growing unease in financial markets.

The implications of recent financial market developments for real activity are hard to assess. Downward

1/ The report, "Current Economic and Financial Conditions," prepared for the Committee by the Board's staff.

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revisions of capital spending plans--particularly of the utilities--may already be under way, judging by the large number of cancellations and postponements of corporate security offerings in recent weeks. Taxexempt issues have also been affected strongly. The larger concerns, however, are, first, that discontinuities in the availability of credit may be developing--for small businesses with bank loans secured by equities for which prices are collapsing, or for borrowers of regional banks having problems in rolling over maturing CD's or selling acceptances-and second, that public confidence is being seriously damaged by growing rumors of troubles plaguing commercial banks and other financial institutions.

Mr. Partee added the following observations:

As Mr. Gramley has emphasized, there are very great uncertainties surrounding any attempt to project the economy in the unusual circumstances that prevail today. Sharply rising prices are draining real consumer purchasing power, and the future performance of financial markets is a major question-mark, both here and abroad. It seems fair to conclude, however, that the main doubts all point in the direction of greater weakness in the domestic economy than is shown by our judgmental projection.

Under these circumstances, it may seem futile to attempt the rather fine policy adjustments that would promise to improve the results of the staff's judgmental projection. But since our projection now foresees a real growth rate of below 1 per cent over the next year--an outcome which would appear to be unacceptable from a public policy point of view--we have attempted to do so. Utilizing differential economic responses based on running the quarterly econometric model with alternative policy assumptions, we conclude that our judgmental projection could be lifted by about 1 percentage point in real terms--to near 2 per cent in total--by raising the assumed money growth rate to 7-1/2 per cent. On this assumption, the fixed-weight price deflator might be about two-tenths of a point higher than in the judgmental projection by the middle

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of next year, but the unemployment rate might be three-tenths of a point lower--reaching about 6.2 per cent rather than 6.5 per cent by the second quarter of 1975.

I know that a 7-1/2 per cent growth rate in the narrowly defined money stock will sound like a great deal to virtually all members of this Committee. Perhaps so. But the problem is that the inflation-past and present--is producing an increase in wage rates and in prices which must be financed, to a degree, if real demand is to be sustained. It is instructive to note that a 7-1/2 per cent growth rate in M1, given the price performance that we are now projecting, would be no more than sufficient to bring the real money stock up to a zero rate of change over the next four quarters of the projection period.

Mr. Morris noted that Mr. Partee, in commenting on the

possible consequences of raising the growth rate of money to

7-1/2 per cent, had considered the period only through the middle

of next year. It seemed to him that a much longer time period had

to be considered in order to evaluate properly the tradeoff between

inflation and unemployment that would be involved in such a change

in target, particularly since the lag in the effects of monetary

policy actions was considerably longer for prices than for employment.

Mr. Partee agreed that a longer time period should be con

sidered if one wanted to make a full evaluation of the price effects

of a higher money supply growth rate. He might note that, accord

ing to the Board's econometric model, the difference in the price

deflator under 5-3/4 and 7-1/2 per cent money supply growth

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rates would grow to about nine-tenths of a percentage point

by the beginning of 1976. He had referred to the implications

of a 7-1/2 per cent money growth rate this morning only because

the real rate of growth in the green book projection was inade

quate; it seemed useful to indicate, as had been done under

similar circumstances in the past, what rate of monetary growth

would be consistent with a more acceptable level of real growth.

He was not necessarily recommending that the Committee adopt the

7-1/2 per cent growth rate as its target; he was simply reporting

that that was judged to be the money growth rate necessary to

support a 2 per cent rate of growth in real GNP.

As he had indicated, Mr. Partee continued, even the GNP

projection presented by the staff this morning, which suggested a

rate of expansion in real output of less than 1 per cent, could

well prove too optimistic. Also, at this critical stage in the

development of the economy, serious problems might develop in

the financial system that would in the end require an increase

in the monetary growth rate considerably larger than anyone

now contemplated.

Mr. Morris remarked that he had been giving a great deal

of thought recently to the Committee's performance during the past

few years, partly in connection with his prospective testimony

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before the House Banking and Currency Committee later this week.

The time horizon used in the staff projections and the Committee's

deliberations was now considerably longer than it had been a few

years ago. In his view, however, that time horizon was still too

short, particularly because of the different lags in the impact of

policy actions on employment and on prices. In general, a time

frame of four quarters was inadequate as a basis for longer-run

planning with respect to monetary policy.

Mr. Partee said he agreed in principle. Recently, however,

as the need for longer-term projections had increased, the staff's

ability to develop reliable projections even for short periods had

seemed to decrease. Of necessity, projections for several years

ahead would be econometric rather than judgmental in nature and

he would have no great confidence in such forecasts under circum

stances such as those now prevailing.

Mr. Morris observed that such projections would at least

give the Committee members a framework--which they did not now

have--for considering the long-run costs associated with particular

short-run objectives.

Mr. Mayo remarked that he found himself in basic agreement

with the staff's analysis of the outlook. However, he would ques

tion Mr. Partee's judgment that a real growth rate of less than

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1 per cent would be unacceptable to the public. Until a few months

ago he (Mr. Mayo) would have agreed with that statement, but it now

seemed to him that a substantial body of support for inflation

control had developed throughout the nation, even among those who

were adversely affected by anti-inflationary policy. He thought

the public at present would be prepared to accept a 1 per cent

growth rate in GNP over the next year if that were required for

better control of inflation.

Mr. Kimbrel asked if the staff would comment on the possi

bility that prices might rise at a much faster rate than projected,

in light of recent large wage increases, widespread strikes, and

apparently strong pent-up demands for higher wages.

Mr. Partee remarked that the staff's recent overestimates

of the rate of growth in real output seemed to have been exceeded

only by its underestimates of the rate of inflation. He might note,

however, that the current projection of price increases allowed

for a distinctly higher rate of wage advance than the previous

projection had.

Mr. Gramley added that the staff had assumed an average rate

of increase in compensation per manhour of a little more than 9 per

cent over the four quarters of the projection period, as compared with

an increase of a little over 8 per cent anticipated 4 weeks earlier.

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He was not prepared to say that he had a great deal of confidence

in the staff's base projection of prices. He was confident, how

ever, that an increase from 1 to 2 per cent in the growth rate of

real output would not in itself result in a price explosion; the

effect on prices was likely to be quite modest.

Mr. Partee noted that the staff's price projection did not

allow for the possibility of significant weakness in commodity

prices. If commodity prices declined sharply, the price increase

projected by the staff might be too high even though employee

compensation rose rapidly. He thought the chances of an over

estimate of the rate of inflation were now about the same as the

chances of an underestimate.

Mr. Hayes said he agreed with Mr. Mayo that the public

would be willing to accept slow growth in real output in order to

achieve effective inflation control. He then asked if the staff

had any observations on the long-term trend of farm prices, which

seemed to have turned up again recently.

In response, Mr. Partee said the staff had not altered its

earlier farm price projections for the period through 1975. The

recent increase in farm prices appeared to be temporary; meat prices

had risen because farmers were holding back animals, and no doubt

would fall when the livestock came to market. Declining expectations

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about crop yields had also contributed to the turnaround in farm

prices, but ultimate crop sizes were still highly uncertain.

Mr. Gramley added that the wheat harvest still looked good,

although not as good as earlier. There also had been sizable reduc

tions in the estimated size of the corn and soybean crops. It

appeared that grain prices had fallen too far and were now return

ing to an equilibrium level, but it was very likely that livestock

prices would decline in the autumn. The staff projection allowed

for a further rise in food prices at an annual rate of 4 per cent,

on balance, for the year ending in mid-1975.

Mr. Hayes noted that the projections suggested a sizable

advance in the unemployment rate. He asked why the staff thought

that rate had been relatively stable thus far.

Mr. Gramley observed that there were two possible explana

tions. First, the level of real GNP might actually be higher than

indicated by the published statistics. That explanation was sug

gested by the sharp decline in productivity implied by the published

figures for the first two quarters of 1974--a decline that was about

1 percentage point greater than anticipated by the Board's econometric

model. The second possible explanation was that it was a consequence

of the unusually slow growth in the labor force.

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Mr. Partee commented that the staff projection allowed

for continued relatively slow growth in the labor force over the

next year. The projections allowed for an increase of 1,300,000

persons; a normal increase over the period would be about 1,600,000

persons.

Mr. Francis noted that crop prospects in the Eighth

District were mixed; the wheat crop was good, but there was an

unusual degree of variation by areas in the development of corn

and, to a large extent, soybeans. He suspected that Department

of Agriculture estimates of corn and soybean harvests would con

tinue to be revised downward.

Mr. Francis added that he shared the feelings expressed

by Messrs. Mayo and Hayes about the greater willingness of the

American public to accept the hardships necessary to control infla

tion. He realized that Mr. Partee, in referring to a 7-1/2 per cent

money growth rate, was not recommending that as a target but, rather,

was describing the money growth he thought necessary to achieve

an acceptable rate of growth of real output. However, in view of

the indications of continuing shortages that he (Mr. Francis) found

both in the red book and in conversations with businessmen, he was

concerned that such a rate of growth in the money stock would simply

confirm expectations of gradually growing inflation.

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Mr. Eastburn remarked that the forecast prepared at the

Federal Reserve Bank of Philadelphia was quite similar to that

presented by the Board staff. Although the Philadelphia projec

tion suggested somewhat more real growth in 1975, he would not

put much weight on the difference. However, the Bank model yielded

consistent increases in both short-term and long-term interest rates.

If one allowed for the lagged effects of recent rapid monetary

growth on future prices and the associated inflation premium, it

would appear that interest rates would rise even more.

Mr. Partee noted that the staff's judgmental projection

suggested gradually rising interest rates, both short-term and

long-term, into 1975; its econometric model yielded even higher

rates over that period. Given the expected large rise in prices

and therefore in nominal GNP, a moderate money supply growth rate

would require a sizable increase in velocity, with consequent

upward pressure on interest rates. On the other hand, if money

were to grow at a 7-1/2 per cent rate, the bill rate--which was

now out of line with the other market rates--might hold fairly

steady over the projection period at about 8 per cent, slightly

above the current level. In general, the higher rate of growth

in the money stock would moderate the rise in interest rates in

the short run.

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Mr. Eastburn observed that, presumably, even with a 7-1/2

per cent increase in money supply, the rise in interest rates would

resume in future years because of the inflation premium.

Chairman Burns remarked that a continued rise in long-term

interest rates would have disturbing implications for the economy.

Under such circumstances, very high price levels would be required

to enable capital-intensive industries to meet fixed interest charges

and to continue to function.

In reply to a question by Mr. Winn, Mr. Partee said one of the

assumptions underlying the staff's projection was that funds would be

appropriated for a large public employment program, involving about

230,000 persons. If the rate of unemployment were to rise sharply,

the Government might institute an even larger program. As yet,

however, not even the program assumed had been funded.

Mr. Winn asked whether it would be better to urge Congress

to move forward with such programs rather than accepting the defeat

in the battle against inflation that would be implied by adopting

a 7-1/2 per cent target for the growth rate of money.

In response, Mr. Partee said he would not consider a tem

porary step-up in the target growth rate for M1 to be a defeat.

Perhaps he should have answered Mr. Eastburn's question more fully

by noting that, even if the money supply were to increase at a

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7-1/2 per cent rate, the rise in real output would not be fast

enough to press against the economy's gradually growing capacity.

The annual rate of growth of real GNP would continue to edge up

throughout 1975, but since it would not be likely to exceed 3 per

cent the rate of inflation should tend to subside over the period.

Of course, if the expansion of the money stock were to continue at

7-1/2 per cent indefinitely, the rate of inflation would eventually

rise. It would be reasonable to expect, however, that the target

growth rate for the money supply would be reduced as the rate of

inflation--and the rate of increase of nominal GNP--slackened.

In short, it should not be impossible to work out a strategy that

would both slow inflation and maintain minimal real growth in the

economy.

The Chairman observed that the whole question was complex

and difficult. One could envision circumstances under which, as

the rate of inflation intensified, even partial accommodation

of the more rapid growth of nominal GNP would require letting the

money supply rise by more than 7-1/2 per cent.

Mr. Gramley noted that there had been a number of comments

about the willingness of the public to accept a 1 per cent growth

rate in real GNP for the sake of controlling inflation. In his

opinion, however, the real issue was whether aiming for such a

low rate of growth would entail a significant risk that the

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economy might slide into a recession. If that occurred, there

undoubtedly would be strong pressures for relaxation of both mone

tary and fiscal policy.

Mr. Mayo expressed the view that that risk would be almost as

great if the Committee aimed for a 2 per cent growth rate in real GNP.

Mr. Mitchell observed that he believed the situation had

come to an impasse of sorts. There were widespread reports of short

ages, but the ability of business decision-makers to deal with the

shortages by expanding capacity was being impeded by high interest

rates. In the past 4 weeks alone, about $2 billion of long-term

debt offerings had been postponed or withdrawn, apparently because

rates were too high. Many businessmen evidently were not willing

to finance in the capital market at prevailing rates because they

expected the rate of inflation to slacken and interest rates to

decline. To the extent that high interest rates were causing

postponement of capital improvements, monetary policy was frus

trating the improvement of supply conditions that was essential

to economic recovery.

Mr. Mitchell then said he expected that the Committee

members who were scheduled to appear at the House Banking and

Currency Committee hearings would find that members of that

Committee, at least, did not share the view that the American

public would accept a 1 per cent growth rate for real GNP.

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Chairman Burns remarked that he had received a different

impression in his appearance before the House Ways and Means

Committee yesterday. He had expressed his view that little or no

economic growth could be expected for some months, and that that

outlook should be accepted as a matter of policy under present

circumstances. None of the members of the Ways and Means Committee,

not even the more liberal members, expressed any shock or criticism.

More generally, in his many recent conversations with Congressmen

he had found widespread acceptance of the need for slow economic

growth; they reported that their constituents were more anxious

about inflation than about unemployment.

In reply to a question by Mr. Sheehan, Mr. Partee said

that in the judgmental model the assumption of a 5 per cent money

growth rate would result in a real growth rate of about zero.

Mr. Sheehan noted that that would entail an even greater

risk of recession than implied by the green book projection. He

asked about the probable near-term effects of a 5 per cent money

growth rate on disintermediation.

In response, Mr. Partee observed that some increase in

disintermediation would be expected because interest rates would

remain high for a time. In addition, that problem would be com

pounded by the issuance of floating-rate notes such as those pro

posed by Citicorp.

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In reply to a question by Mr. Morris, Mr. Partee said that

the judgmental projection called for housing starts to remain stable

at about 1.5 million units through the end of 1974 and to drift

down next year--to 1.4 million units by the second quarter of 1975.

There was, of course, a real risk that starts would fall substan

tially faster.

Mr. Wallich asked if the upward revision in the projected

increase in compensation per manhour was reflected in a proportion

ate rise in consumption in the staff's judgmental model.

Mr. Gramley replied that the projection of disposable income

had been increased on that ground, and the increase had tended to

raise projected consumption expenditures. However, because current

data suggested a lack of consumer willingness to spend, the saving

rate was projected to remain at around 6-1/2 per cent.

Mr. Wallich noted that a 1 per cent addition to the rate

of advance in employee compensation amounted to about $8 or $10

billion. Such a large amount of money should result in a consider

able improvement, either in savings flows or in consumer spending.

Mr. Partee observed that an $8 to $10 billion increase in

income would amount to less than the drain on real income result

ing from the oil price increases of last winter.

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Mr. Wallich then asked whether the continuing rise in

industrial prices was still predominantly a demand-pull phenom

enon, resulting from shortages and bottlenecks, or whether cost

push factors were now predominant.

Mr. Partee said there was reason to believe that the rise

in prices of manufacturers' industrial materials was primarily

cost-push; with the ending of controls, firms had been attempting

to restore profit margins. He thought it was unlikely that the

recent abnormally high rate of increase in industrial commodity

prices would persist.

Raw materials prices, Mr. Partee continued, had shown some

tendency to slip in recent months; on balance, the Federal Reserve

commodity price index had moved down since early April. The

decline had not been large, however, and there appeared to be suf

ficient demand for the time being, perhaps resulting from inventory

stocking, to maintain raw materials prices at close to current levels.

Mr. Wallich remarked that he would feel uncomfortable with

a real growth rate as low as 1 per cent. While he was prepared to

incur some risks in the interest of achieving the Committee's

objectives, that rate was close to the brink. He would prefer

a growth rate about half way between zero and the economy's

potential. He thought, however, that other forecasters on balance

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expected economic growth to be somewhat stronger than the staff

projection, and he personally felt that there was good reason for

that expectation. In particular, it appeared to him that the staff

projection was unduly influenced by the assumed growth rate of the

narrowly defined money stock; he noted that some of the other mone

tary aggregates were expected to be stronger than M1.

Before this meeting there had been distributed to the

members of the Committee a report from the Manager of the System Open

Market Account covering domestic open market operations for the

period June 18 through July 10, 1974, and a supplemental report

covering the period July 11 through 15, 1974. Copies of both

reports have been placed in the files of the Committee.

In supplementation of the written reports, Mr. Holmes made

the following statement:

There was a sharp deterioration in financial market conditions, both domestic and international, over the period since the Committee last met. An excess of investor caution virtually dried up the capital markets and a further move towards selectivity played havoc with the money market. The viability of individual banks was called into question by many observers, a few large industrial firms dropped CD's completely from their investment portfolios, and most investors became still more reluctant to purchase CD's issued by any but the top banks. There was also some evidence of a deposit shift from regional to money market banks.

REIT's and utility firms found it increasingly difficult to borrow in the commercial paper market and some bank holding companies found themselves in

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the same unenviable position. The acceptance market was faced with a substantial supply of bills and had its own problems as the withdrawal of a major acceptance dealer from the market forced many smaller banks to seek new outlets. Interest rates--except for Treasury bills--rose sharply in almost all sectors of the market, leading to new fears of disintermediation. The inability of some borrowers to find funds in the market at any price forced many of them to take down lines at their commercial banks, increasing pressure on the latter to seek funds.

In this atmosphere, banks became very cautious. This attitude first became apparent around the June statement date and has continued ever since. Despite the exceptionally high Federal funds rate, banks were reluctant to come to the discount window, presumably hoping to keep their record clear for even rainier days. In fact, on several days last week, special borrowing at the window by the beleaguered Franklin National Bank exceeded the borrowing of all other member banks in the country. The actual average level of borrowing fell sharply below the anticipated $2 billion figure, creating a need for the Desk to add to nonborrowed reserves to make up for the shortfall in borrowing at the window.

Despite concerted action by the Desk to carry out the Committee's instructions, including those arising out of the July 5 telephone meeting and the Chairman's recommendation included in the telegram of July 10, we have not yet been able to bring the funds rate all the way down. Reserve-supplying operations have been large and have taken place on every working day. Given the long-run nature of the reserve need, we would have preferred to do more outright buying than was actually the case. But the shortage of securities, particularly in the Treasury bill area, proved to be a real, and disturbing, constraint. As it was, we purchased in the market $900 million of Federal agency issues in three go-arounds, $175 million of Treasury coupon issues, and only $289 million of Treasury bills. RP's had to be our standby, and these came to a total of about $11 billion--a very high figure.

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Our frequent appearance in the market--and the low level of bank borrowing--led a few market observers to conclude that the System is in process of abandoning its tight monetary policy. Others, looking at the

high level of the Federal funds rate and of borrowing costs, have concluded that the System has tightened its policy since the last meeting, despite the relatively good behavior of M1 and M 2 . All of this just

adds to the confusion in the market, which was already ample. There are still others who believe that System policy is basically unchanged but that the current psychological state of the markets makes interest rate relationships completely unpredictable if not completely

unintelligible. I should note that foreign transactions were sizable during the period, involving System purchases and sales that about offset one another--until

yesterday when we were able to buy over $200 million of Treasury bills from foreign accounts. One transaction involved the purchase of $129 million short-term Treasury bills from foreign central banks and the sale of a like amount of longer-term bills to an oil-producing country to complete the large order that was mentioned

at the last Committee meeting. Today we will be investing $400 million for another oil-producing country, but expect that the Treasury will be taking care of part of the order by issuing special securities.

Looking ahead, our reserve estimates indicate a need to supply reserves in the next two statement weeks.

We shall endeavor to make substantial additional outright purchases of securities. But dealers are still

in a net short position in Government securities and availability is not likely to be great, particularly if foreign buy orders are large. There is an avail

ability of agency issues and bankers' acceptances, and we plan to buy both, although the amount that

can be done in acceptances is limited--particularly

on a day-to-day basis. We shall again, undoubtedly, have to rely heavily on RP's. If it appears likely

that we will be unable to provide reserves in the

desired amount because of collateral shortages, we will

so inform the Chairman. Contingency planning is obvi

ously the order of the day.

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As far as the Treasury is concerned, it has just announced a $1.5 billion, 9-month note issue by the Federal Financing Bank, that institution's first issue. Since the Committee has decided to treat FFB issues in the same way as Treasury issues, the same even keel considerations should apply to the FFB as to the Treasury. Since the securities in this particular issue are short-term and will be sold at auction, no problems appear to exist. Later this month the Treasury will announce the terms of its August refunding of $4.4 billion publicly-held maturing issues. Even keel considerations should prevail for that financing, although even keel is hard to define in these parlous days. The Treasury expects to raise about $7 billion in new money between now and mid-September, but concrete plans have not yet been finalized. Actual Treasury needs will depend on how many special issues will be made to foreign monetary authorities, particularly those of oil-producing countries.

It is somewhat ironic that strenuous efforts are being made to attract oil money to our markets at a time when both our money and capital markets are in disarray. There is some consolation in the fact that domestic financial markets abroad and the Euro-markets are also in disarray. A return to greater stability in our financial markets would obviously be a matter of great significance for the entire world financial system. In this respect, it is equally obvious that we must continue to remain alert to developing circumstances in all the financial markets and be prepared to act as best we can in response to any new development.

Mr. Bucher said he understood that supply constraints were

the factor limiting the Desk's outright purchases of Treasury bills

and bankers' acceptances. He asked about the extent to which out

right purchases of agency issues and Treasury coupon issues were

being limited by similar technical considerations of availability,

as opposed to judgments by the Manager regarding the possible

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effects of additional purchases of such securities on market

psychology.

In reply, Mr. Holmes remarked that the limitations on

outright securities purchases in the recent period were primarily

technical in nature. With respect to Treasury bills, the problem

was wholly one of availability. To illustrate, one day last week

the Desk had encountered great difficulty in executing foreign

account orders to buy $70 million of bills--a small amount by

normal standards. In the bankers' acceptance market, the problem

was not one of reduced availability but rather of the nature of

the market; it simply was not possible to trade in large blocks.

It was feasible, however, to buy a substantial volume of accep

tances over a period by acquiring relatively small amounts from day

to day. Agency securities could be acquired in volume; as he had

noted, $900 million had been purchased in the 4 weeks since the

last Committee meeting.

The availability of Treasury coupon issues was more limited,

Mr. Holmes continued. The Desk was particularly alert to opportu

nities to acquire coupon issues from dealers who, while holding

no inventories of their own, did have sell orders from customers

wanting to liquidate their holdings. He might note that banks

recently had liquidated a smaller volume of Treasury issues than

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he had expected; they had found it preferable to use their holdings

as collateral on repurchase agreements.

Mr. Mayo asked whether it would be correct to infer from

Mr. Holmes' remarks that the Treasury had resolved any questions

it might have had earlier with respect to the desirability of per

mitting oil-producing countries to invest their revenues in special

Treasury issues.

Mr. Holmes replied that the basic decision to proceed with

such issues had been made. However, a number of details remained

to be worked out.

Mr. Mayo then asked about the likely spreads between the

yields on issues of the Federal Financing Bank and those on other

market securities. He noted that one of the advantages anticipated

from the establishment of the Bank was that its securities would

be viewed by the market as more similar in character to Governments

than to agency issues.

Mr. Holmes remarked that, in general, he would expect the

yields on FFB securities to be closer to those of Governments than

to agencies of comparable maturity. Given the current state of

financial markets, however, there was some uncertainty about the

performance of the initial FFB offering. On balance, he thought

it probably would perform quite well, particularly in light of the

strong demand for short maturities.

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Mr. Morris said he was concerned about the possibility

that over the longer run the System's ability to supply reserves

in the amounts desired would become increasingly impaired by the

restricted availability of securities in the market. The System

had made no significant change in its reserve-supplying techniques

for a number of years; one proposal to be considered later today-

to increase the authorized holdings of bankers' acceptances--would

be constructive, but it was quite limited in scope. He thought it

would be desirable to have a staff committee appointed to consider

possible new means of supplying reserves to the market.

Chairman Burns remarked that the study Mr. Morris had pro

posed might be combined with an examination of the extent to which

the Desk's problems would be alleviated by a change in the mix of

Treasury issues.

After further discussion, it was agreed that a staff

committee should be appointed for the purposes mentioned.

Secretary's note: On July 18, 1974, the Committee was advised that Chairman Burns had named the following to serve on the indicated staff committee: Mr. Holmes, System Account Manager; Mr. O'Connell, General Counsel; and Mr. Axilrod, Economist (Domestic Finance), Chairman.

Mr. Black said he had been interested to note in the green

book that for the first time the staff had reliable reports that

Arab oil proceeds were being placed in market investments other

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than Treasury bills. He asked what such investments might imply

for rate pressures on CD's, bankers' acceptances, and other such

securities.

Mr. Holmes replied that, while he had no firm information

on the volume of oil revenues being invested in various types of

private securities, such investments thus far did not appear large

enough to have a significant impact on relative interest rate

levels.

Mr. Eastburn noted that in earlier discussions of the

causes of the rise in the Federal funds rate to levels above 13

per cent, a good deal of stress had been placed on technical

factors. He asked whether those factors were thought to explain

the continuing high funds rate or whether some more basic forces

appeared to be at work.

Mr. Holmes expressed the view that the original upsurge

in the funds rate had been touched off by developments related to

the end-of-June bank statement date and the Fourth of July holiday.

In explaining the persistence of the high rate, however, he would

lay greater stress on attitudes in the market, including the will

ingness of many banks to pay extremely high rates for funds in

order to avoid borrowing at the discount window.

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Chairman Burns asked whether the difficulties being

experienced by some banks in rolling over or expanding their

outstanding CD's were not also a contributory factor, and Mr.

Holmes responded affirmatively.

Mr. Balles remarked that on the basis of his own commercial

banking experience he could fully understand the reluctance of many

large banks--even those with severe liquidity problems--to use the

discount window at present. Since they did not know how long the

present degree of monetary restraint would continue, it was reason

able for them to want to preserve their rights of access to the

window for possible use at a time when the need might be even greater.

In the meantime, they were willing to pay a very high rate for

Federal funds. From the standpoint of the Federal Reserve, however,

the approach those banks were following was counter-productive; in

particular, it aggravated the Desk's difficulties in attempting to

achieve the Committee's reserve objectives while also keeping the

Federal funds rate within the targeted range. That led him to

wonder whether it might not be desirable for the System to inform

the banks--particularly those that were encountering serious

difficulties in rolling over CD's and in acquiring Federal funds-

that it was prepared to relax its standards for borrowing a bit,

both in terms of the maximum amounts that might be borrowed in any

given week and the number of weeks for which borrowings might remain

outstanding. It would be unfortunate in his judgment, if the member

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banks were permitted to believe that the System's usual ground

rules for adjustment credit would prevail throughout a period of

near-crisis conditions, even though increased use of the window

would offer positive benefits in alleviating the Desk's problems

in providing reserves.

Mr. Hayes observed that he also had been wondering whether

it might not be desirable to encourage some additional member bank

borrowing. He was not sure, however, that it would be necessary

to make any change in the System's rules; at least in the Second

District, most banks had ample leeway to borrow under the existing

rules.

Mr. Coldwell noted that when the System had followed such

an approach on a previous occasion, only one member bank in the

country had responded. He understood that that bank--which happened

to be located in the Eleventh District--had later regretted its

action.

Mr. Holland remarked that on the occasion referred to by

Mr. Coldwell, the System had not limited itself to offering assis

tance at the window; it had restricted the types of loans that could

be made by banks accepting that assistance. In retrospect, he believed

the approach followed then had not been the best. More generally,

there were several different ways in which the Federal Reserve might

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pursue the objective of having a somewhat higher proportion of

bank reserves provided in the form of borrowings. He might men

tion that questions of that kind would be considered by the new

"Discount Policy Group", chaired by Mr. Axilrod, which had been

established in connection with the reorganization of the Board's

staff management functions announced today.

Chairman Burns observed that it might be possible to

achieve the results Mr. Balles sought without precipitating an

avalanche of borrowing by having Reserve Bank officials in each

District ask member banks about the reasons for the low level of

borrowings.

Mr. Francis commented that such a procedure might appear

strange to banks that had recently been asked to terminate their

borrowings.

Mr. Winn said he also would see problems with the suggested

procedure in light of the current level of the discount rate rela

tive to market interest rates. Encouraging banks generally to

borrow more could be interpreted as rewarding those that had been

operating aggressively. He might note in that connection that

two nonmember.banks in his District had applied for access to the

window last week not because they were in difficulty but simply

because they found the rate so attractive.

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Mr. Winn then referred to the Manager's comment that dealers

were still in a net short position in Government securities, and

asked whether Mr. Holmes found that situation disturbing. He also

asked who was responsible for policing the Government securities

market.

Mr. Holmes replied that the current short positions made

open market operations more difficult than they otherwise would be.

From a different point of view, he was concerned about the large

number of due bills issued by banks, not all of which would be

reflected in the available statistics. The problem of due bills

might be resolved by a proposed regulatory measure the Board had

published for comment. On the second question, while there was no

formal assignment with respect to policing the market, informally

he considered that to be part of his responsibility.

Mr. Axilrod added that that function also was performed

to some extent by the joint Treasury-Federal Reserve staff committee

on the Government securities market which had been in existence for

a number of years.

Mr. Holmes said he might report that the Federal funds

rate had finally dropped below 13 per cent; according to informa

tion he had just received, it was now trading at 12-1/2 per cent.

He should add that one swallow did not make a summer.

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By unanimous vote, the open market transactions in Government securities, agency obligations, and bankers' acceptances during the period June 18 through July 15, 1974, were approved, ratified, and confirmed.

Mr. Axilrod made the following statement on prospective

financial relationships:

As you can see from the blue book,1/ the staff expects that the funds rate would need to drop back to around the 12 per cent area if money supply growth is not to fall short of the Committee's longer-run desires as expressed at the last meeting.

Many factors, of course, influence the relationship between money growth and interest rates, in particular the Federal funds rate. Special influences driving the Federal funds rate up to the 13-1/2 per cent level over the past few weeks have been noted in the documentation presented to the Committee and by the Manager in his report this morning. There is no need for me to repeat all of these. But I do want to highlight the reasoning that lies behind our view that the rate would probably decline if the Committee were to stay on its longer-run path adopted at the last meeting.

The basic reason is that we believe the upward move in the funds rate in good part reflected a downward shift in banks' willingness to supply money to the public and not an upward shift in the public's demand for money. Such a downward shift in the supply function would manifest itself in a reduced willingness to borrow from the Federal Reserve by banks and an increased tolerance for excess reserves for a given level of the Federal funds rate. Last week member bank borrowing, other than emergency borrowing, had

1/ The report, "Monetary Aggregates and Money Market Conditions," prepared for the Committee by the Board's staff.

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declined to only about $1-1/4 billion, a level that last spring was associated with a funds rate of around 10 per cent. Excess reserves, too, were running above spring levels. This means that reserves supplied by open market operations were being absorbed by banks' increased demand for free reserves and were not, therefore, available to support bank credit and deposit growth.

I very much doubt that member banks' demand for borrowing from the Federal Reserve at a given funds rate has been permanently reduced, however. Discount officers on a conference call late last week did report that many large city banks had indeed been making it a policy to stay out of the window recently, but the officers thought this was mainly an effort by banks to attain a clean record so as to insure access to the window in case of even more stringent liquidity pressures later. Nevertheless, so long as demand for borrowing is reduced, given the funds rate, the Desk would have to increase its reserve-supplying operations in order to prevent total reserves from falling short,

Provision of more reserves through open market operations and consequent stabilization of the funds rate would, of course, be inappropriate if the underlying trend in demands for money and credit were changing. For example, under current circumstances, if the recent sharp rise in the funds rate reflected a strengthening of GNP and associated transactions demands for money--or if there were increased precautionary demands for cash by the public--stabilization of the rate at about 12 per cent would lead to greater expansion in bank reserves and more money growth than the Committee desired. We have no evidence, however, of such a strengthening in GNP; staff estimates on the contrary have been moving toward greater weakness. And M1 in recent weeks at least has been on a plateau, showing no growth from the beginning of June to early July.

Providing more reserves to keep the funds rate from rising would also be inappropriate if the rise in the funds rate merely reflected a restructuring of the yield curve in short-term markets--with one-day rates rising and other rates falling. This could happen if market participants thought a climax in

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credit market pressures was at hand; borrowers would attempt to keep their liabilities as short as possible in an effort to reduce interest costs over time. Banks, for example, would tend to borrow in the Federal funds market rather than by issuing CD's.

There has probably been some focusing of interest rate pressures on the overnight market during the past week or two as fears of financial difficulties have become somewhat more widespread, partly in the wake of the Bank Herstatt failure, and risk premiums have become much larger in credit markets. Some regional banks appear to be experiencing difficulty in rolling over CD's and in the short run they would have to turn to the funds market; they probably would be willing to pay something of a premium rate in that market.

While some of the recent rise in the funds rate does reflect increased uncertainties in financial markets and views that a climax may be near at hand, the exact chain of cause and effect is not totally clear. The rise in the funds rate and its persistence at around 13-1/2 per cent has also influenced market attitudes and other short-term rates. As a result, other short-term rates, apart from Treasury bills, have moved up into closer alignment with the high funds rate. In other words, rather than simply reflecting a reshaping of the yield curve, the high funds rate has recently been pulling the whole short-term rate structure upwards.

In conclusion, my assessment of the evidence suggests that the recent rise in the funds rate reflects a reduction, probably temporary, in member banks' willingness to borrow. It may also reflect other adjustments being made more generally as liquidity pressures mount, but we are not seeing any compensating decline in other rates as one might expect if pressures were being transferred to the funds market. The rise in the funds rate does not appear to reflect a strengthening of credit and money demands. Thus, if and as the high funds rate leads to a persistently higher short-term rate structure, monetary restraint will become more intense.

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Mr. Mitchell asked about the effects of the recent large

international flows of funds on domestic interest rates and on

the degree of tightness in domestic money markets.

In reply, Mr. Axilrod observed that Treasury bill rates

had been depressed relative to other rates by,among other things,

bill purchases for foreign official accounts. Also, uncertainties

in the Euro-dollar market resulting from the Bank Herstatt failure

no doubt had contributed to the rise in the Federal funds rate

around the time of the end-of-June bank statement date, by affecting

market psychology and perhaps also by leading to some temporary

diminution in the availability of Federal funds through foreign

agencies and branches. However, he did not believe that the per

sistence of the high Federal funds rate could be explained in terms

of international developments. And while international flows of

funds had clearly affected the structure of domestic interest rates,

he did not believe they had any necessary consequences for the

average level of domestic rates so long as the Committee remained

willing to pursue particular objectives with respect to bank

reserves and money. While others might disagree, he would not

attribute any significant part of the current money market tight

ness directly to recent international flows.

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Mr. Mitchell then asked about the sources of the Treasury

bills that had been purchased recently for foreign official accounts.

Mr. Axilrod replied that some of those bills had been

supplied from the System's portfolio. He had no information at

the moment regarding the ultimate suppliers of the remaining bills

that were bought in the market through dealers. The staff was now

making a longer-run assessment of changes in ownership of Treasury

debt which might throw some light on that question.

Mr. Holmes remarked that a substantial volume of the bills

the dealers had acquired in recent weekly Treasury auctions had

been resold immediately to foreign official accounts.

Mr. Coldwell asked if the staff would comment on the

effects on M1 of shifts of funds between foreign official balances

and Treasury balances, such as might arise from the purchase of

special Treasury securities for foreign official accounts.

Mr. Axilrod replied that staff members had debated ques

tions of that type over the years without reaching a consensus.

Personally, he thought such transactions had no significant last

ing effects on M1 because they did not reflect a shift in money

demand, given interest rates. Ordinarily, the bulk of the funds

originally transferred to the foreign accounts would probably have

been raised by liquidating investments in market securities, rather

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than by reducing money balances. Private deposits would be

reduced in the process of effecting the transfer of funds. The

funds would pass through foreign deposits and would then lodge in

Treasury balances if the foreigners invested in Treasury specials.

Such an increase in the Treasury balance would reduce the need for

Treasury cash borrowing--or permit the Treasury to repay market

debt--and that would in effect return cash to the market, as would

occur more directly if the foreign account itself bought securities

in the market rather than from the Treasury.

Mr. Mitchell noted that, depending on the nature of the

transactions, the outcome could be affected by the fact that the

money stock was defined to include foreign official deposits. He

asked about the justification for such a definition.

Chairman Burns remarked that that question was a technical

one which could lead to extensive discussion. While he was dubious

about the desirability of defining M1 to include foreign official

deposits, he thought the Committee should not take the time to

debate the matter now.

Mr. Winn noted that the growth rates of other monetary

aggregates had been higher than that of M1 over the first half of

1974, apparently as a result of a shift toward money substitutes.

He asked whether the Committee should not be taking greater account

of the paths of those aggregates rather than focusing primarily on M1.

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In reply, Mr. Axilrod remarked that the first-half growth

rates of M 2 and M3, while still above that of M1, had dropped con

siderably from the average of the three preceding years, whereas

the M1 growth rate had not. That pattern was expected to persist

over the second half of the year; under alternative B, for example,

the growth rate of M2 was expected to be only about 1 percentage point

higher than, and that of M3 about the same as, the growth rate of

M1. As he had indicated at the previous meeting, restraint was

now focused more on M2 and M3 than it had been in past periods of

tight money.

The Chairman then called for the Committee's discussion

of monetary policy and the directive.

Mr. Hayes remarked that the principal change in recent

weeks seemed to him to have been an increase in the degree of

unease in domestic and international financial markets. Obviously,

the strained state of those markets and the possibility of further

failures posed very real risks at this point. Nevertheless, he

thought the battle against inflation might be entering a critical

stage also. It had been apparent all along that a monetary policy

capable of bringing that fight to a successful conclusion would

entail risks. It now appeared that it would be necessary to live

with those risks for some time to come. The problem would be to

avoid going beyond prudent limits of restraint.

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Mr. Hayes said he thought it was clear that the Committee

had to focus its attention on money market conditions at this time.

With regard to the aggregate targets, however, he would prefer to

hold to the moderate growth rate objectives the Committee had set

for the second half of the year. He recognized that it might be

impossible to maintain sufficient pressures in the financial

markets to achieve those objectives. For the present, however,

he would retain the existing longer-run targets of 5-1/4 per cent

for M1, about 6 per cent for M2, and 9-1/4 per cent for the bank

credit proxy. The 5-1/2 per cent M1 target shown in the blue book

under alternative B also would be acceptable to him. As to the

July-August tolerance ranges, 3 to 6 per cent for M1 and 5-1/2 to

7-1/2 per cent for M2--which were reasonably close to the ranges

shown under alternative B--would be acceptable.

The more difficult, and more pertinent, questions related

to the range for the Federal funds rate, Mr. Hayes observed. Rates

averaging at or close to 13-1/2 per cent over the past 2-1/2 weeks

were clearly well above what the Committee had intended. He would

not add to the comments already made on the reasons for the recent

high funds rate, but he would note that it remained desirable to

try to get that rate back to something closer to what the Committee

had had in mind at the previous meeting. Given the prevailing

conditions in the market, there was no easy formula for doing that;

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it would be necessary to give the Manager an unusual degree of dis

cretion at this time. He would suggest a range of 11-1/2 to 13

per cent, with the understanding that the Manager would seek to nudge

the rate back to the 12 to 12-1/2 per cent area if market conditions

made that at all possible, He would use the relatively high upper

limit of 13 per cent to avoid forcing an undue volume of reserves

on the market if the special factors that had produced the high

rate should persist.

As for the directive, Mr. Hayes observed, he preferred an

operational paragraph couched in terms of money market conditions

in place of the staff's alternatives.1/ He would suggest the fol

lowing language: "To implement this policy, the Committee seeks

to maintain restrictive money market conditions while taking account

of the unusually sensitive conditions prevailing in domestic and

international financial markets, the special factors that have

affected the markets for bank reserves in recent weeks, and the

forthcoming Treasury financing."

The Chairman remarked that there was much to be said for

Mr. Hayes' language. However, he would prefer a final clause reading

"while taking account of the sensitive conditions prevailing in finan

cial markets and the forthcoming Treasury financing."

Mr. Hayes said that revision would be acceptable to him.

1/ The alternative draft directives submitted by the staff for Committee consideration are appended to this memorandum as Attachment D.

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Mr. Mayo expressed the view that the degree of monetary

restraint in place was just about right, given the complications

in the present situation. Despite his earlier comment regarding

the willingness of the public to accept slow economic growth to

achieve some lessening of inflation, he would not want to see any

increase in restraint. He was almost completely in accord with

the specifications shown under alternative B; in particular, he

thought an M1 target growth rate of 5-1/2 per cent for the second

half of the year would be consistent with the Committee's previous

policy stance and with good--although not perfect--inflation con

trol over the remainder of 1974.

About the only modification he would make in the alterna

tive B specifications, Mr. Mayo continued, would be to widen the

short-run ranges of tolerance for growth rates in the July-August

period. As he had indicated at other recent meetings, he con

sidered a 2 percentage point range too narrow. Thus, he would

prefer a range of 2 to 6 per cent for M1 growth in July-August,

in place of the 4 to 6 per cent range shown in the blue book. He

would have no problem in accepting the range of 11 to 13 per cent

shown for the Federal funds rate under alternative B, particularly

since the rate had declined into that range today. For the direc

tive, he would prefer the language of alternative B to that sug

gested by Mr. Hayes.

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Chairman Burns noted that neither Mr. Hayes nor Mr. Mayo

favored an intensification in the degree of restraint at this time,

and neither favored an easing of policy. He concurred in those

views. In order to provide a focus for the discussion, he might

suggest some possible specifications for the members' considera

tion. For the longer-run M1 target, he proposed retaining the

5-1/4 per cent growth rate for the second half of the year that

the Committee had agreed upon at its previous meeting. For the

July-August ranges of tolerance, he suggested using the upper

limits shown under alternative B but reducing each of the lower

limits somewhat. Specifically, the ranges would be 2 to 6 per cent

for M1, 4-1/2 to 7-1/2 per cent for M2, and 8-3/4 to 11-3/4 per cent

for RPD's. For the Federal funds rate, the range would be 11-1/2

to 13 per cent.

Mr. Francis said he would find acceptable either the

specifications for the aggregates shown under alternative B or

those proposed by the Chairman. As he had often noted in the past,

he favored reducing the emphasis placed on the Federal funds rate.

It was his impression that the markets had adjusted better than

many would have expected to the higher funds rate levels that

developed in recent weeks, and his present inclination would be

to focus solidly on the aggregates and let the markets adapt to

whatever funds rate emerged.

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Mr. Morris asked how the Manager would expect to implement

specifications along the lines of alternative B.

In reply, Mr. Holmes noted that the Desk's most recent

objective had been to bring the funds rate down to 13 per cent,

and to permit the rate to move lower if the market carried it down.

That had not been achieved until today, and--as he had suggested

earlier--today's decline might prove temporary. The Desk's more

general objective over the past several weeks had been to maintain

a funds rate in the neighborhood of 12 per cent. He would inter

pret adoption of the alternative B specifications as reflecting a

desire by the Committee to have the funds rate brought down to

about 12 per cent, assuming that could be done without flooding

the market with reserves,

Mr. Morris remarked that, in light of that interpreta

tion, he would support the modified version of the alternative B

specifications for the aggregates proposed by the Chairman. With

respect to the Federal funds rate, however, he would be happy with

the original alternative B range of 11 to 13 per cent; he did not

understand the Chairman's purpose in suggesting that the lower

limit be raised to 11-1/2 per cent.

Chairman Burns said his purpose could be simply stated.

If the funds rate, which recently had been around 13-1/2 per cent,

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were to decline to a level as low as 11 per cent, the drop would be

likely to be interpreted by the market as an easing of Federal

Reserve policy. Such an interpretation would be unfortunate at

this time.

Mr. Morris asked whether a decline in the funds rate to,

say, 12 per cent would not produce a similar reaction.

The Chairman replied that that was a possibility. He might

note, however, that open market operations throughout the recent

period in which the funds rate had been well above 13 per cent had

probably made it clear to the market that the Desk was trying to

bring the rate down. He asked whether the Manager agreed with

that view.

Mr. Holmes said he did. He went on to comment that in

his view a decline in the funds rate to levels significantly below

12 per cent was likely to be over-interpreted by the market. Some

participants were now predicting that the Federal Reserve would

ease up a bit to help the Treasury in the forthcoming refunding

and then tighten up again after the refunding was over.

Chairman Burns remarked that he also had another considera

tion in mind. In private conversations with both Administration

officials and Congressmen, he had been urging that some steps be

taken in the direction of fiscal restraint. While he could not

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describe the prospects of success as clearly good, the possibility

of some success was more than a faint one. In his judgment, how

ever, that possibility would be reduced if at this juncture the

System were to take actions that were publicly interpreted as

easing.

Mr. Coldwell said he thought it was necessary for the

Committee to recognize the uncertainties in financial market

conditions at present. He would be somewhat concerned about

adopting any of the staff's alternatives for the operational

paragraph of the directive, since all of them focused on rela

tionships between money market conditions and monetary aggregates.

He would prefer language along the following lines: "To implement

this policy, the Committee favors a restrictive posture both in

terms of money market conditions and the rate of growth in mone

tary aggregates, while taking account of the forthcoming Treasury

financing and the uncertain conditions in the domestic and inter

national financial markets."

With respect to specifications, Mr. Coldwell continued,

his first choice for the aggregates would involve growth rates

1/4 to 1/2 of a percentage point below those suggested by the

Chairman. There was not much point in debating so small a dif

ference, however, and he was prepared to accept the Chairman's

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figures. He favored a range for the Federal funds rate of 11-1/2

to 13-1/2 per cent.

Mr. Balles remarked that the staff's outlook for the

economy could be summarized as follows: over the next 12 months

the growth rate in real GNP would be 1 per cent or less; the rate

of inflation would still be about 6 per cent in the second quarter

of next year; and the unemployment rate would be about 6-1/2 per cent

at that time. That sort of summary drove home an unpleasant truth

about monetary restraint--namely, that the bad news, in the form of

a dampening of business activity, came first, and the good news, in

the form of a diminished rate of inflation, came later. He would

urge the Committee to face up to that unpleasant truth and hold to

its present course; if it failed to do so, he feared that it would

simply make no progress in reducing the rate of inflation.

Mr. Balles said he would like to associate himself strongly

with Mr. Morris' view about the desirability of lengthening the

planning horizon for monetary policy. It was important that the

Committee try to assess the eventual effects of its policy actions

as well as it could, given the limitations of economic forecasting.

While knowledge regarding lags was certainly limited and far less

precise than one might like, it was nevertheless clear that the

lag in the effect of a policy change on prices was somewhat longer--

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perhaps considerably longer--than the lags with respect to the

impact on production and employment.

Mr. Balles then expressed the view that it was necessary

to keep a careful watch on the CD, Federal funds, and commercial

paper markets. As the members no doubt were aware, some unhealthy

developments were occurring in those markets as a consequence of

the Franklin National and Bank Herstatt problems. For example,

the senior financial officer of a large West coast industrial

company had recently mentioned that he planned to recommend that

the firm withdraw completely from investments in CD's and commercial

paper and move exclusively into Treasury securities, in order to

avoid the risk of unknown weaknesses of large banks. In the course

of a lengthy discussion, he (Mr. Balles) had expressed shock and

dismay at such a plan and had noted that if many firms pursued

that course they would create the very conditions they would be

trying to protect against. Subsequently, the financial officer had

indicated that the firm's decision had been far less Draconian.

Still, it involved limiting holdings of CD's to those issued by

the 10 largest banks in the country and drastically paring the

number of companies whose commercial paper would be bought.

Mr. Balles observed that such decisions by bank customers

would put great pressures on some banks not among the largest

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even though they might be in an essentially sound condition. He

had had that fact in mind earlier today when he had suggested that

the System stand ready to offer assistance through the discount

window to banks experiencing such pressures. He would make a sharp

distinction between banks that were suffering the consequences of

their own imprudent behavior--in making excessive loan commitments

and granting excessive lines of credit--on the one hand, and banks

that had kept their loans under control but were experiencing prob

lems mainly because of a sudden diminution in their ability to

roll over CD's on the other hand. While the System might offer

some discount window assistance to banks in the first group, it

should also let them incur the capital losses that would be involved

in sales of Treasury and municipal securities as part of a program

to restore their liquidity positions. However, he would be inclined

to take a more generous attitude toward banks in the second group,

because their problems would be a consequence of the frightened

atmosphere in financial markets and not of their own making.

With respect to today's policy decision, Mr. Balles con

tinued, he agreed with those who thought the System now had about

the right degree of restraint in place. He had intended to suggest

a slight shading of the specifications shown under alternative B,

and could easily concur in the Chairman's suggestions. He saw

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nothing wrong with the directive language associated with

alternative B.

Mr. Kimbrel said he was not unmindful of the scattered

questions being raised about the solvency and liquidity of some

financial institutions. He hastened to add, however, that he

hoped the System would not overreact. He still found rather wide

spread acceptance of the need to continue efforts to contain infla

tion, even on the part of those experiencing extreme pressure. In

view of recent monetary growth rates, he found it difficult to

believe that the System's policy was unduly restrictive.

Turning to the directive, Mr. Kimbrel observed that a

money market formulation might tend to raise questions regarding

the Committee's determination to control growth in the aggregates.

Accordingly, he would prefer to cast the directive in aggregate

terms. In his view, it would be desirable under present circum

stances to give the Manager somewhat more leeway than usual while

seeking to maintain the present degree of restraint. He would

be reluctant to have the Federal funds rate remain above 13 per cent

for long. He would be even more reluctant, however, to have it

fall below 12 per cent in the very near term because of the likeli

hood that such a drop would be erroneously interpreted as a premature

move toward ease. The specifications the Chairman had suggested

were quite acceptable to him.

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Mr. Eastburn observed that he also found the Chairman's

specifications quite acceptable. In his own thinking about mone

tary policy he had been trying to separate questions of strategy

and tactics. As far as strategy was concerned, he believed the

point made earlier about the need to lengthen the policy planning

horizon was entirely correct. If there had been any deficiency

in the Committee's procedures over the last year or so, it lay in

an unduly narrow focus on the short run. The consequence was that

the longer-run targets had been missed.

However, Mr. Eastburn continued, he thought tactical con

siderations were of particular importance at this time. The more

closely one observed market conditions, the more fully one appre

ciated that fact. In recent weeks, for example, there had been

a sharp and inexplicable decline in the prices of the stock of

certain Philadelphia banks, in some cases amounting to 20 or 25

per cent in a very short period. Moreover, the bank suffering

the largest reduction in its stock prices was probably one of the

two most liquid in the city. It was clear, as Mr. Balles had sug

gested, that some banks were victims of circumstances beyond their

control. The existence of such situations made it necessary for

the Committee to consider carefully the tactics it employed in

attempting to reach its strategic goals.

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Mr. Eastburn expressed the view that the specifications

suggested by the Chairman blended quite well the needs of longer

run targets and short-run tactics. He would like to see the Federal

funds rate kept near the upper end of the indicated range; he had

the impression that maintenance of the rate at about 13 per cent

would have a beneficial effect on the market, and that a reduction

to 12 per cent not only was unnecessary but might in fact produce

mistaken assumptions about the Committee's intentions. For direc

tive language he continued to prefer an aggregative to a money

market formulation, and he liked the language of alternative B.

Mr. Black said he thought all members of the Committee

agreed that inflation was the main problem, that close control

over the monetary aggregates was consequently necessary, and that

such a course involved serious risks. There were differences of

view regarding the point at which those risks arose and regarding

their magnitude. In his judgment, the risks were now acute; the

possibility of imminent and dangerous financial disruption had to

be contemplated.

Under such circumstances, Mr. Black continued, it might

be a mistake for the Committee to try to adhere too closely to

any specific numerical targets for the monetary aggregates. He

would be inclined to think in terms of some outer limits beyond

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which the Committee would not press in the interest of reducing

the risk of financial collapse. For the present the Committee

should give priority to maintaining the viability of financial

markets and to insuring the kinds of flows through those markets

needed to finance the capital expansion that was vital for the

longer-term solution of the inflation problem.

For the coming inter-meeting period, Mr. Black observed,

he would favor continuing to focus on money market conditions.

The modified alternative B specifications the Chairman had sug

gested seemed generally appropriate. He would not be overly

concerned if it proved necessary to permit the growth rates in

the aggregates to run somewhat above the longer-run target rates

in order to keep the funds rate below 13 per cent. He hoped,

however, that the funds rate could be kept generally within the

11-1/2 to 13 per cent range without permitting unduly rapid growth

in M, and M 2 .

As to the directive, Mr. Black said he favored retaining

the money market formulation adopted at the preceding meeting.

If the members were inclined toward the formulation of alterna

tive B, however, he would suggest revising the staff's draft to

indicate that the Committee sought to achieve bank reserve and

money market conditions "consistent with moderate growth" in

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monetary aggregates, rather than that it sought to achieve condi

tions "that would moderate growth" in the aggregates. He hesitated

to add another candidate to the list of possible directives, but

he thought such language would come closer to expressing the objec

tive he favored than did the original language of alternative B.

Mr. Clay remarked that he agreed with the statement in the

blue book that the possibility of a credit crunch in financial

markets could not be ignored. However, that potential problem,

as well as others, was in large part a consequence of the infla

tionary environment and would persist until inflation was brought

under control. He felt that the possibility of a credit crunch

existed in any program that was designed to reduce inflation and

that did not validate past inflation.

Mr. Clay said it was becoming obvious that the Committee

could not get inflation under control by continuing to maintain

an average growth rate of 7 per cent in M1, as suggested under

alternative A. Neither could it get low interest rates over the

long run by following such a policy. Moreover, even though alterna

tive B called for a moderation in the growth rate, the specifications

implied a year-over-year increase in M of 6.4 per cent, which would

be in excess of the 6.1 per cent increase achieved last year. Alter

native B also contemplated a substantial reduction in the funds

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rate, which under current conditions would appear to require an

undesirably large injection of nonborrowed reserves.

Accordingly, Mr. Clay continued, while he would accept

the wording of alternative B, he would prefer specifications that

fell between those of alternatives B and C. Specifically, he

would recommend target growth rates for the third and fourth

quarters combined of 4-3/4 per cent for M1, 5-3/4 per cent for

M2, and 6-3/4 per cent for the bank credit proxy. Associated

ranges for the July-August period would be 3-1/2 to 5-1/2 per cent

for M1, and 5 to 7 per cent for M2 . That set of specifications

would result in an M, growth rate of 6 per cent for 1974, which was

virtually the same as that for 1973. A Federal funds rate range

of 12 to 13-1/2 per cent would appear consistent with those targets.

However, Mr. Clay observed, he doubted that the specifica

tions he recommended would be acceptable to the Committee. He

thought the specifications proposed by the Chairman were a step

in the right direction--indeed, he preferred them to any of the

alternatives shown in the blue book--and he would be prepared to

accept them for the period immediately ahead.

Chairman Burns then asked Mr. Partee for his policy

recommendations.

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Mr. Partee remarked that the specifications the Chairman

had proposed struck him as satisfactory for the time being. He

would not be stating his views in full if he failed to add that,

in his judgment, the time at which it would be necessary to move

toward ease was rapidly approaching. However, he could see the

strategic value, in terms of dampening inflationary psychology,

of maintaining what appeared to be an extreme posture of restraint

in the money market for a while. He would recommend the alterna

tive B language for the directive. It was important that the

Committee pay close attention to the behavior of the aggregates

at this point because there now was a good possibility that they

would slacken sharply. If that happened, he thought the Committee

should be prepared to move promptly to bring down money market rates.

Mr. Holland said he favored holding to about the present

general degree of monetary restraint between now and the next

meeting. It would be necessary to be especially watchful for

potential failures of financial firms. Moreover, the Committee

should be aware of the possibility that there might now be unduly

depressive pressures on the monetary aggregates, even on M1; there

was a chance that when the members looked back on the period from

the beginning of June to the end of August they would decide that

growth in all of the major monetary aggregates had been less than

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they would have liked. While the odds on such a development were

probably less than even, the fact that it was a possibility should

be kept in mind as the System shaped its contingency plans and

policies. In particular, the Federal Reserve should have contin

gency plans at hand for use in case it proved necessary to help

meet liquidity needs on short notice.

With respect to the directive, Mr. Holland observed that

he favored language along the lines of alternative B, which referred

to both money market conditions and the aggregates. He thought the

modification Mr. Black had suggested would be desirable, in light

of the chance that the aggregates might now be expanding too slowly.

He preferred the specifications the Chairman had suggested to those

shown in the blue book under alternative B. If, as his instincts

suggested, the aggregates would be growing somewhat less in the

near term than projected, he would not want the Manager to respond

by easing money market conditions rapidly or substantially. Accord

ingly, he favored reducing the lower limits of the 2-month ranges

for the aggregates, as the Chairman had proposed. He hoped, how

ever, that the Desk would work actively to bring the Federal funds

rate down into the desired range, and to move it gradually lower

within that range so long as the growth rates in the aggregates

were well below their upper limits or were drifting down. And, if

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market pressures again tended to push the funds rate up above

13 per cent, he hoped the Desk would act against those pressures

more aggressively than it had during the recent period, and that

the Manager would communicate promptly with the Chairman so that

the Committee could review the situation.

Finally, Mr. Holland remarked, he would urge the Desk to

place considerably more weight on purchases of bankers' acceptances

as it used the various means available to it for supplying reserves.

That would be to kill several birds with one stone: it would help

relieve the problem of shortages of other types of securities

ordinarily purchased in reserve-supplying operations; it would

improve conditions in a particular market that was now under pres

sure; and it would indirectly have a helpful impact on markets for

other private short-term paper. He noted that later in this meet

ing the Committee would be considering a recommendation to increase

the limit on the volume of bankers' acceptances that the Desk

could acquire.

Mr. Wallich said he saw no occasion for further tightening

at this time, in light of the evolving economic situation. He

agreed with the staff's assessment of the outlook for prices but he

thought that their projections of real growth might be on the low

side. If so, nominal GNP would rise more than projected. However,

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the resulting increase in the demand for money would tend to be

offset by the somewhat higher level of interest rates. Accordingly,

he believed the alternative B targets as modified by the Chairman

were about right.

Mr. Wallich remarked that he would favor formulating the

directive in terms of the aggregates, partly because there was

greater public acceptance of such targets at present than of targets

formulated in terms of money market conditions. Also, he would be

uneasy about specifying a narrow range for the Federal funds rate

in view of the uncertainties ahead and the possibility of marked

upward or downward pressures on that rate. He recognized that it

was necessary to avoid a large decline in the funds rate, since

such a decline would certainly be misinterpreted.

Mr. Bucher said he would like to put a question to the staff

before expressing his views on policy. A number of speakers today

had implied that the adoption of specifications similar to those

of alternative B would amount to maintaining the present posture

of policy. According to the blue book, however, any declines in

market interest rates that might develop under the B specifications

were likely to be modest and short-lived, because of the inflationary

environment, continuing strong private credit demands, and Treasury

and agency financings. If adoption of the B specifications resulted

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after a brief period in rising interest rates, he wondered whether

market participants were not likely to conclude during the next

month that the Committee had in fact tightened policy.

In reply, Mr. Axilrod noted that the alternative B specifi

cations were roughly consistent with the monetary assumptions under

lying the staff's basic GNP projections. If those projections were

realized, growth in nominal GNP would be considerably faster than

growth in M1, and the resulting demands for money and credit would

tend over the longer run to raise interest rates. A temporary

decline in rates was expected during the next few weeks simply

because rates had recently shot above their trend path. He did

not believe, however, that adoption of the alternative B specifica

tions would be perceived by the market during coming weeks as a

tightening action, because under those specifications the funds

rate would drop back toward 12 per cent. If anything, market par

ticipants might conclude that policy was a shade easier than it

had been in the past 2 weeks. They probably also would conclude

that the money market conditions that emerged were those the

Committee had originally sought.

Mr, Bucher then said it was important to keep in mind that

the task of purging the economy of inflation was going to be a long

and difficult one. He agreed that the war against inflation should

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be the number 1 priority. However, the Committee might very well

lose that war by focusing too intently in the short run on the

battle of the monetary aggregates. He would be prepared to accept

the risks involved in suggesting to observers for a few weeks or a

month that policy was tending to ease. Such risks should not be

permitted to overwhelm other, more important, considerations,

particularly since any temporary impressions of that sort could

readily be reversed by clear indications that the System was deter

mined to maintain a generally restrictive policy stance over the

longer run.

At the moment, Mr. Bucher continued, the war against infla

tion had strong support in the Congress and among the public at

large. But those positive attitudes could be changed quickly by

such developments as a crisis in financial markets, a slide over

the brink into recession, or even a fairly early run up in the

unemployment rate. While he was willing to incur some risks in

that regard, a monetary policy that was expected to result in growth

of less than 1 per cent in real GNP over the next year was too close

to the brink. He would prefer to aim at a slightly higher rate of

growth--perhaps on the order of 2 per cent, which Mr. Partee had

suggested would require expansion in M at a 7-1/2 per cent rate.

In terms of the blue book alternatives, he would favor the

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specifications of alternative A, which included a longer-run target

for M1 growth of 7 per cent.

In sum, Mr. Bucher remarked, he was prepared in the short

run to give observers the impression of a slight easing of policy,

in the expectation that over the longer run the System would be

able to convince them that it was continuing its determined battle

against inflation. He would like to see the weekly average Federal

funds rate reduced below 12 per cent, and he would favor more aggres

sive operations toward that end, including purchases of coupon and

agency issues. Also, he concurred in Mr. Holland's comments about

operations in bankers' acceptances. As to directive language, he

favored alternative A, which called for bank reserve and money

market conditions "consistent with growth in the monetary aggre

gates at about the rates prevailing over recent months."

Mr. Sheehan said he agreed in general with the views expressed

by Mr. Black. He thought it would be desirable to aim at a small

positive growth rate in real GNP--perhaps of 2 per cent or a bit

under--in order to minimize the risks of creating a recession or

contributing significantly to one. If the real growth rate were

kept positive the Committee would experience less pressure to ease

from the Congress and the public and would be better able to continue

its fight against inflation.

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Mr. Sheehan noted that the recent unexpected increase in

the Federal funds rate had been attributed to technical factors.

Accordingly, he was disturbed by the suggestion that a return to

the level originally contemplated would be construed by the market

as an easing action. He would not dissent if a Committee majority

favored the specifications suggested by the Chairman, but he was

uneasy about the prospect of a funds rate as high as 13 per cent.

Unlike Mr. Francis, he was not pleased with the way in which the

market had adjusted to rates well above 13 per cent; in his view,

conditions had come too close to the precipice for comfort. He

had been satisfied with the degree of tension in financial markets

prior to the run-up in the funds rate, and he would now like to

move back from the precipice if that could be done without recreat

ing the pattern of last autumn. At that time, as the members

would recall, the Committee had attempted to ease slightly, and

market conditions had outrun its intentions. On the whole, he

thought a funds rate of about 12 per cent or a little less would

be appropriate at this time.

Mr. Mitchell remarked that he could agree with the policy

views of almost every prior speaker, including Mr. Francis, in the

sense that those views fell within his own range of tolerance for

policy. He also shared the apprehensions of a number of speakers

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about conditions in financial markets and the deeply troubled

position of some banks. At present the capital markets were not

functioning properly, nor were the markets for commercial paper

and, apparently, bankers' acceptances. He would like to think

the System was developing an effective approach to the problem of

dealing with the troubled institutions that, in effect, were

causing some markets to function inadequately or not at all.

As to the directive, Mr. Mitchell continued, the language

Mr. Hayes had originally proposed had a strong appeal because it

recognized the existing difficulties in financial markets. On

balance, however, he favored the language of alternative B on

the pragmatic grounds Mr. Wallich had advanced. He was quite

willing to accept the specifications the Chairman had suggested.

Mr. Winn observed that the notion of brinksmanship in

policy suggested incorrectly that there was only one way to fall;

dangers lay in both directions, and it would be better to say that

the Committee was walking a tightrope. He would hesitate to give

a signal at this stage that would be interpreted--or misinterpreted-

as easing. On the other hand, no one wanted to bring down the house

of cards. He would feel comfortable with the modified B specifi

cations the Chairman had suggested, assuming that the Desk would

not be expected to be highly aggressive in its efforts to reduce

the Federal funds rate to 12 per cent.

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Mr. Van Nice said he favored the alternative B specifica

tions as shown in the blue book. He would prefer to focus a bit

more at this time on money market conditions than on the aggregates;

he was not sure about the validity of the relationship between money

market rates and growth rates in the aggregates involved in the B

specifications, and if money market rates were found to be moving

above or below the desired range he would favor accepting some

deviation in the aggregates from their target growth rates, even

growth in M1 at a rate above the 5-1/2 per cent longer-run target

shown in the blue book.

Mr. Van Nice then said he had the impression that,

while the public continued to support the posture of monetary

policy, there had been some change in sentiment during the past

few weeks. Specifically, businessmen seemed much more worried

than a month ago that the situation was very close to the brink.

If the spread of such attitudes required a decline in the Federal

funds rate to 11 per cent or even lower, he would not be unduly

concerned so long as that was a temporary phenomenon. In the

long run the financial community was likely to base its impressions

of monetary policy on the growth rates recorded for the aggregates

rather than on fluctuations in the funds rate in either direction.

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Chairman Burns observed that there appeared to be a broad

consensus within the Committee with respect to specifications, so

that the main question to be resolved concerned the directive. He

asked for an indication of preferences between operational paragraphs

which emphasized monetary aggregates on the one hand, and money market

conditions on the other.

A majority of the members expressed a preference for emphasis

on the monetary aggregates.

Mr. Holland noted that Mr. Black had suggested that the

alternative B language be modified to call for conditions "consistent

with moderate growth in monetary aggregates" instead of conditions

"that would moderate growth in monetary aggregates." He thought

there were advantages to that suggestion. He might note, first,

that the alternative B language implied that the Committee sought

slower growth in the aggregates over the second half of the year

than in some base period. Such an implication would be quite appro

priate if the second quarter were taken as the base. However,

assuming the July projections under alternative B were realized,

the average growth rates for the aggregates in the 3 months ending

in July would be below the second-quarter rates and quite close

to the rates the Committee apparently favored for the second half.

If that period were viewed as the base, it would be more appropriate

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to call simply for "moderate growth"--a construction the Committee

had used on many occasions--and avoid the implication that the

objective was to drive growth rates down still further.

Mr. Hayes commented that Mr. Black's proposed language

suggested an easier policy stance than the directive adopted at

the previous meeting, which called for maintaining "about the

prevailing restrictive money market conditions." He preferred

the alternative B language, whichdid not convey a suggestion of

easing.

After further discussion, the Chairman asked for an expres

sion of preferences between Mr. Black's proposed language and that

of alternative B. A majority indicated that they favored the latter.

Chairman Burns then suggested that the Committee vote on a

directive consisting of the general paragraphs as drafted by the

staff and alternative B for the operational paragraph. It would

be understood that the directive would be interpreted in accordance

with the following specifications. The longer-run targets--namely,

the annual rates of growth for the third and fourth quarters com

bined--would be 5-1/4, 6-1/2, and 7-1/2 per cent for M1, M2, and

the bank credit proxy, respectively. The associated ranges of

tolerance for growth rates in the July-August period would be 8-3/4

to 11-3/4 per cent for RPD's, 2 to 6 per cent for M1, and 4-1/2 to

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7-1/2 per cent for M2 . The range of tolerance for the weekly

average Federal funds rate in the inter-meeting period would be

11-1/2 to 13 per cent.

Mr. Bucher indicated that he planned to dissent from the

proposed directive.

With Mr. Bucher dissenting, the Federal Reserve Bank of New York was authorized and directed, until otherwise directed by the Committee, to execute transactions for the System Account in accordance with the following domestic policy directive:

The information reviewed at this meeting suggests that real output of goods and services changed little in the second quarter and that no significant expansive forces appear to be emerging. The over-all rate of price rise, while very large, was not quite so rapid in the second as in the first quarter, but the advance in wage rates accelerated. In June industrial production was unchanged, following 2 months of moderate advance, while nonfarm payroll employment edged down. The unemployment rate remained at 5.2 per cent. Wholesale prices of farm and food products declined substantially further, but increases among industrial commodities continued widespread and extraordinarily large.

Since mid-May the dollar has appreciated somewhat against leading foreign currencies. In June there was a large increase in foreign official assets in the United States, mainly reflecting investments by oil-exporting countries. The foreign trade deficit increased sharply in May, as exports declined and imports rose further.

Growth in the narrowly defined money stock was some

what more rapid in June than in May; growth during the second quarter was close to the 7 per cent first-quarter pace. Net inflows of consumer-type time deposits at banks

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and at nonbank thrift institutions increased in June, but deposit experience at the nonbank institutions deteriorated late in the month. Growth in business loans and in total bank credit slowed in June, and banks added much less to their outstanding volume of large-denomination CD's than in April and May. Private market interest rates have risen substantially in recent weeks, and in association with uneasy conditions in financial markets, yield spreads between prime and lower quality issues have widened. Yields on long-term Government securities have increased relatively little, and those on Treasury bills have declined somewhat.

In light of the foregoing developments, it is the policy of the Federal Open Market Committee to foster financial conditions conducive to resisting inflationary pressures, supporting a resumption of real economic growth, and achieving equilibrium in the country's balance of payments.

To implement this policy, while taking account of the forthcoming Treasury refunding and of developments in domestic and international financial markets, the Committee seeks to achieve bank reserve and money market conditions that would moderate growth in monetary aggregates over the months ahead.

Secretary's note: The specifications agreed upon by the Committee, in the form distributed following the meeting, are appended to this memorandum as Attachment E.

Chairman Burns noted that a memorandum from the Account

Manager, dated July 9, 1974, and entitled "Outright System Activity

in the Agency Market," had been distributed to the Committee.1/

He asked Mr. Holmes to comment.

Mr. Holmes said he believed his memorandum, and the attached

memorandum from Mr. Ozog reviewing outright System operations in

1/ A copy of the memorandum referred to has been placed in the Committee's files.

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agency issues since their inception in September 1971, were self

explanatory. The recommendations contained in his memorandum were

that the guidelines governing agency operations be amended by drop

ping guidelines 4 and 7. Elimination of those guidelines would

permit the roll-over of maturing agency issues and the purchase

of new agency issues on the issue date rather than after a 2-week

"seasoning" period. The first recommendation, if adopted, would

avoid the negative reserve impact that occurred when agency secu

rities matured. While that reserve impact had been manageable, it had

become larger as the System's portfolio of agencies had increased.

The second recommendation would increase the availability of agency

securities for System purchase, since the bulk of transactions in

the agency market consisted of trading in new issues.

Mr. Holmes remarked that the adoption of both recommenda

tions should help in over-all reserve management in the present

unusual circumstances, in which Treasury bills had become scarce

commodities and dealer positions had become virtually non-existent.

After discussion, the Committee agreed that the Manager's

recommendations should be approved.

By unanimous vote, the guidelines for the conduct of System operations in Federal agency issues were amended, effective immediately, to delete guidelines numbered 4 and 7, and to renumber the remaining guidelines as 4, 5, and 6.

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The Chairman then noted that a memorandum from the Manager,

dated July 10, 1974, and entitled "Limit on Outright Holdings of

Bankers' Acceptances," had been distributed to the Committee.1/ He

asked Mr. Holmes to comment.

Mr. Holmes observed that a memorandum from Mr. Cooper dated

July 10, 1974, a copy of which was attached to his own memorandum

to the Committee, included a recommendation that the Federal Reserve

Bank of New York drop its policy of requiring dealers to add their

endorsement to any acceptances purchased by the Desk for either

System or foreign accounts if the Committee approved a second recom

mendation: to increase the limit on outright holdings of bankers'

acceptances, contained in paragraph 1(b) of the Authorization for

Domestic Open Market Operations, from $125 million to $500 million.

Given the volatile state of the markets, and the fact that the two

recommendations were quite separable, the Federal Reserve Bank of

New York had dropped that endorsement requirement last Friday. The

action was welcomed by the dealers, who were concerned both about

investor reluctance to buy paper except that of the largest banks

and about the size of their contingent liability--close to'$1 billion-

on endorsements made on behalf of the Federal Reserve.

1/ A copy of the memorandum referred to has been placed in the Committee's files.

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As Mr. Cooper's memorandum indicated, Mr. Holmes continued,

the endorsement policy was an archaic one adopted in the earliest

days of the System and viewed originally--at least in part--as a

means of encouraging the market by adding to dealer income. Drop

ping the requirement would result in a small dollar saving to the

System that would more than offset any additional cost that an

expansion of activity might entail.

Mr. Holmes remarked that enlarging the portfolio limit to

$500 million would be a modest help in the System's reserve-supply

ing activity in the present period of shortages of Government secu

rities, and it should give some encouragement to the market. It

would also put the Desk in a position to handle any foreign sale

of acceptances should the market not be able to do so. He might

note that since last Thursday the Desk had expanded its operations

in acceptances, and its holdings of acceptances were now at the

present $125 million limit.

Mr. Holmes added that some publicity had been given to the

constraint of the $125 million limit on System purchases of accep

tances. Accordingly, if the Committee approved the increase, he

thought the action should be made public promptly.

Mr. Morris asked whether a larger increase than the Manager

had recommended might not be desirable, in view of the shortage of

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other securities of the types the Desk normally purchased in

supplying reserves.

In reply, Mr. Holmes expressed the view that a limit

of $500 million would not constrain the Desk from making necessary

purchases of bankers' acceptances for some time. Should such a

limit appear likely to become a constraint, he would plan on

recommending a further increase to the Committee. He would not

recommend setting a higher figure now because of the possibility

that market participants would assume that the System planned to

make purchases on a larger scale than actually contemplated.

After further discussion, it was agreed that Mr. Holmes'

recommendation should be approved.

By unanimous vote, paragraph 1(b) of the Authorization for Domestic Open Market Operations was amended, effective immediately, to read as follows;

To buy or sell in the open market, from or to acceptance dealers and foreign accounts maintained at the Federal Reserve Bank of New York, on a cash, regular, or deferred delivery basis, for the account of the Federal Reserve Bank of New York at market discount rates, prime bankers' acceptances with maturities of up to nine months at the time of acceptance that (1) arise out of the current shipment of goods between countries or within the United States, or (2) arise out of the storage within the United States of goods under contract of sale or expected to move into the channels of trade within a reasonable time and that are secured throughout their life by a warehouse receipt or similar document conveying title to the underlying goods; provided that the aggregate amount of bankers' acceptances held at any one time shall not exceed $500 million.

7/16/74

Mr. Broida noted that on June 27, 1974, he had distributed

a memorandum to Committee members and Reserve Bank Presidents not

currently serving, asking whether they would prefer to shift the

October 15 meeting date listed on the tentative schedule for 1974

either to October 16 or October 22, in view of the fact that the

day preceding October 15 was Columbus Day, a national holiday.1/

While a number of the respondents indicated that they would prefer

not to meet on the day following a holiday, two advised that they

would have major conflicts if the meeting were shifted to October 16,

and two reported that such conflicts would be produced by a shift

to October 22. Accordingly, he suggested that the Committee retain

the October 15 date shown on the tentative schedule.

There was general agreement with that suggestion.

It was agreed that the next meeting of the Committee would

be held on August 20, 1974, at 9:30 a.m.

Thereupon the meeting adjourned.

Secretary

1/ A copy of the memorandum referred to has been placed in the Committee's files.

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ATTACHMENT A

. CHAIRMAN OF THE BOARD OF GOVERNORS

FEDERAL RESERVE SYSTEM WASHINGTON,D C 20551

July 16, 1974

The Honorable William E. Simon Secretary of the Treasury Department of the Treasury Washington, D. C.

Dear Bill:

In view of the possibility that you may be engaging in talks about the provision of financial assistance to Italy, I am writing on behalf of the Federal Open Market Committee to clarify the status of the $3 billion reciprocal currency arrangement (swap line) between the Federal Reserve System and the Bank of Italy.

The swap facility can be drawn on subject to the conditions and limitations arising from its nature and purpose. It has always been understood by both central bank parties to the swap arrangement that swap drawings are available only to meet short-term needs. Drawings are normally made for a period of three months, and while they may sometimes be renewed, it is in no case envisaged that they will remain outstanding for longer than one year. Therefore the swap line cannot be used to make any contribution to medium-term or long-term financing needs.

In present circumstances, recognizing that

(a) the Italian authorities now appear to be taking substantial actions toward bringing about needed adjustments in the domestic Italian economy and in the Italian balance of payments, and that

Th Honorable William E. Simon July 16. 1974 Page 2

(b) some time may be needed to arrange an appropriate package of external financial assistance for Italy,

the Federal Reserve System would be prepared to allow the Bank of Italy to make some use of its swap line for interim, short-term financing purposes.

We have had no specific discussions with the Bank of Italy about this. But, for your information, the Federal Open Market Committee which decides these matters has been thinking along the following lines. It would be appropriate for the Bank of Italy -in anticipation of obtaining longer-term financing -- to draw, say, $250 million initially, and to draw up to an additional $250 million subject to conditions to be specified, such as that Italy obtain commensurate amounts on comparable terms from other sources, including other central banks and particularly the U. S. Exchange Stabilization Fund. It would be expected that these drawings would be repaid within three months, subject to periodic extensions, if necessary, up to one year.

For any drawings by the Bank of Italy on the System beyond $500 million, the Committee would expect, in addition to commensurate Italian drawings on other sources, that firm take-out provisions would be negotiated (e. g. , by the pledge of proceeds from prospective IMF drawings or of gold collateral), so that the repayment of such swap drawings within one year would be assured.

I am sure you will agree that it would be helpful if you were to note, should the subject of the System's swap arrangements arise in your talks, that decisions concerning these arrangements are in the province of the Federal Open Market Committee.

Sincerely yours,

Arthur F. Burns

ATTACHMENT B

Henry C. Wallich July 16, 1974

Report on the BIS Governors' Meeting - July 8, 1974

In place of the usual survey of country problems, the

following issues received fairly intensive discussion:

(1) Guidelines or rules for liquidity, solvency, and

for exchange exposure of banks.

(2) Lender-of-last-resort responsibilities.

(3) Redepositing of reserves by central banks in the

Eurodollar market.

(4) The Herstatt failure.

(5) (at the dinner meeting) Possible use of OPEC funds

by the BIS.

(1) Guidelines

Gordon Richardson described the approach of the Bank of

England as focusing principally upon the quality of management.

Within this context, the Bank of England, he said, judges the

adequacy of a bank's free reserves and its liquidity ratio. The

Bank obtained detailed data on the maturity structure of Eurocurrency

operations each quarter, which so far had shown no unsatisfactory

trend. Failure to maintain adequate liquidity in terms of asset

liability structure leads to a discussion of the Bank of England

with the individual bank. As regards foreign exchange positions,

the Bank of England sets individual limits on the open position

against sterling for each bank, as well as on the position of spot

against forward. No limits are placed on positions in currencies

other than sterling, but this might have to be explored in future.

Clappier (France) indicated that France had tight control

over its banks but that foreign currency transactions still remained

in part uncontrolled. The Bank of France is working with the

commercial banks on an information procedure covering the foreign

currency position as well as the relation between the maturity

structure of assets and of liabilities. Commercial banks are

interested in and receive the resulting composite information on

a voluntary basis.

Vandeputte (Belgium) said that Belgian controls over the

capital ratios of banks had become more lenient in recent years. The

spot and forward position in each currency for each bank was watched

by the authorities. Controls are maintained only on the over-all

open position in Belgian francs but not for each currency.

Zijlstra, Richardson, Clappier, and Vandeputte expressed

an interest in developing more information on exchange positions and

in possibly coordinating this information internationally.

(2) Lender-of-Last-Resort Function

Richardson laid out in detail what he considered proper

policy with respect to particular banks.

(a) For British banks the Bank of England would assume full

responsibility if it considered support to be justified.

(b) For consortium banks, he saw no way of assigning

responsibility but hoped that the prestigious banks participating

in the consortium banks would stand back of their subsidiary.

(c) For wholly or majority owned foreign subsidiaries,

the Bank of England would feel a certain responsibility to enlist

support to insure a healthy banking system within its own country.

This responsibility would be met, however, by seeking to enlist the

help of the central bank of the majority shareholder.

(d) In cases where the difficulties experienced were in

dollars, Richardson hoped that assistance would be forthcoming from

the Federal Reserve if the amounts in dollars required proved an

embarrassment to the Bank of England.

Klasen (Germany) agreed with Richardson's assignment of

responsibility to central banks as lender of last resort in cases

where assistance was justified. He entered general reservations,

however, regarding the appropriateness of assistance.

I pointed out that it was difficult to generalize about

lender-of-last-resort responsibilities, referring to the difference

between liquidity and solvency problems, between branches and sub

sidiaries, to problems of availability of collateral, of the degree

of supervision that a foreign central bank could exercise over

branches and subsidiaries of its banks abroad, and of the supervision

and regulation applied by the host country authorities. I added

-4-

that a central bank had to be strongly conscious of its responsibilities

as lender of last resort but that these had to be viewed also in the

context of whether the problem was a macro or a micro problem, whether

the need was to provide liquidity for a whole market or to bail out a

particular institution, and how a rescue operation could be reconciled

with the over-all needs of monetary policy.

(3) Redepositing in the Eurodollar Market

Several representatives, especially those of England, Italy,

and Holland, suggested that the "self-denying ordinance" not to

place central bank reserves back into the Eurodollar market might

have to be lifted. Their objective apparently was to increase the

lending power of the Eurodollar market, reflecting a concern that a

growing proportion of the OPEC money will flow to New York. Klasen

spoke against the proposal. His concern was with the inflationary

consequences of this redepositing, which in effect creates additional

Eurodollars. I supported him on the same grounds and also by pointing

out that it is not attractive for the U.S. to find that other countries

in effect are creating dollars which could give rise to lender-of

last-resort responsibilities. No clear decision was reached on this

matter.

(4) Herstatt Failure

Klasen described the circumstances leading to the decision

to close the Herstatt bank. He regretted the losses suffered by

American banks, which, he said, were shared by German banks, but

absolved the German authorities from responsibility. Wallich and

Coombs argued that the world payment mechanism was affected by

the failure and that the liquidity of some American banks was

affected by the delays that had had to be imposed on the clearing

mechanism in order to guard against further losses. Failure to

undo the damage to American banks, Coombs said, would lead the

market to regard spot purchases and sales of exchange as credit

transactions and would slow the mechanism as well as hurt small

banks trying to deal in spot exchange. No strong complaints were

voiced by European central bankers, contrary to expectations,

about the slowing of the clearing mechanism in New York.

(5) BIS Recycling of OPEC Funds

At the dinner meeting, Zijlstra spoke of the possibility

that the BIS might soon receive very substantial OPEC funds, and

examined the terms on which the BIS could accept and relend these.

The principles he set forth, which were not universally endorsed,

involved (a) no active solicitation of funds on the part of BIS,

(b) the need for the BIS to obtain guidance on the political

decision involved in choosing among potential borrowers, and (c) the

need of the BIS for guarantees by the EEC or a wider group against

losses. Zijlstra's discussion of the prospects of such a deal was

not sufficiently precise to permit this possibility to be built into

any particular assistance package that might have to be discussed

outside the BIS in the near future.

ATTACHMENT C

Helen B. Junz

July 30, 1974

Summary notes on OECD's Economic Policy Committee Meeting - June 24-25, 1974

In their meeting in June 1974, members of the Economic Policy

Committee (EPC) took up once again the dialogue that had started in

November of last year: while there was unanimous agreement that the

main policy concern was the need to bring the rapid increase in the

level of prices under control, there was disagreement about how this

should be accomplished. At the February 1974 meeting concern had

shifted toward the danger of a cumulative recession in the wake of the

oil crisis. However, at the time of the OECD Ministerial meeting in

May 1974 countries had already swung back toward giving priority to

the need to control inflation. And this view was put forward even

more forcefully during the meeting of the EPC.

Countries were, however, divided in their view whether

sufficient restraint had already been put in train in order to achieve

the goal of moderation in inflation rates or whether continued, and

perhaps even further, restraint was needed. Those countries who felt

that continued restraint was needed (U.S., Germany, Italy, Japan,

France, Australia, Austria, Belgium, Netherlands, Switzerland, Ireland,

and Greece) argued essentially that inflationary trends had been accele

rating long before the oil crisis and that a relatively prolonged cool

ing off period, during which economic growth would be rather less than

the long-term trend would indicate, was necessary in order to eliminate

inflationary expectations. A majority of these countries favored

traditional demand management tools to accomplish their objective.

In the event that generalized restraint might cumulate to a more

severe downturn than was expected, most of these countries were pre

pared to take the downside risk, arguing that it would be easier to

deal with excess deflation than with rampant inflation.

Those countries who felt that sufficient restraint had

already been built into the System (U.K., Canada, the Scandinavian

countries, Spain, Portugal, and New Zealand) argued that the downside

risks were too high, particularly because there was no assurance that

lower inflation rates would actually be achieved in this manner. They

believed that very low rates of output would be accompanied by a fall

off in productivity, leading in turn to higher unit labor costs and

a situation of stag- or even slump-flation. Under these conditions,

there was the added risk that trade positions would move into even

greater imbalance than existed currently. Thus, prolonged generalized

restraint would lead to a cumulative downturn, which might be followed

by overly reflationary measures and renewed inflationary pressures,

i.e., a classical stop-go cycle. The countries in this group thus

preferred demand management policies designed to run their economies

at pressures of demand that would minimize the downside risks. In

addition, they favored the use of selective measures, such as subsidies,

tax relief of various sorts, and other measures aimed at moderating

wage demands.

With respect to the achievement of better external balance,

prescriptions also differed. Countries in generally weak positions

felt that surplus countries should relax demand restraints as early

as possible and maintain a level of growth approaching full capacity

(U.K., France, Italy, the Scandinavian countries, Ireland, and

New Zealand), while the stronger countries felt that their main con

tribution lay in helping to moderate world inflation (U.S., Germany,

Japan, and Austria).

ATTACHMENT D

Drafts of Domestic Policy Directive for Consideration by the Federal Open Market Committee at its meeting on July 16, 1974

GENERAL PARAGRAPHS

The information reviewed at this meeting suggests that real output of goods and services changed little in the second

quarter and that no significant expansive forces appear to be

emerging. The over-all rate of price rise, while very large,

was not quite so rapid in the second as in the first quarter, but the advance in wage rates accelerated. In June industrial

production was unchanged, following 2 months of moderate advance, while nonfarm payroll employment edged down. The unemployment rate remained at 5.2 per cent. Wholesale prices of farm and food products declined substantially further, but increases

among industrial commodities continued widespread and extraordinarily large.

Since mid-May the dollar has appreciated somewhat against leading foreign currencies. In June there was a large increase in foreign official assets in the United States, mainly reflecting investments by oil-exporting countries. The foreign trade deficit increased sharply in May, as exports declined and imports rose further.

Growth in the narrowly defined money stock was somewhat more rapid in June than in May; growth during the second quarter was close to the 7 per cent first-quarter pace. Net inflows of consumer-type time deposits at banks and at nonbank thrift institutions increased in June, but deposit experience at the nonbank institutions deteriorated late in the month. Growth in business loans and in total bank credit slowed in June, and banks added much less to their outstanding volume of large-denomination CD's than in April and May. Private market interest rates have risen substantially in recent weeks, and in association with uneasy conditions in financial markets, yield spreads between prime and lower quality issues have widened. Yields on longterm Government securities have increased relatively little, and those on Treasury bills have declined somewhat.

In light of the foregoing developments, it is the policy of the Federal Open Market Committee to foster financial conditions conducive to resisting inflationary pressures, supporting a resumption of real economic growth, and achieving equilibrium in the country's balance of payments.

OPERATIONAL PARAGRAPH

Alternative A

To implement this policy, while taking account of the forthcoming Treasury refunding and of developments in domestic and international financial markets, the Committee seeks to achieve bank reserve and money market conditions consistent with growth in the monetary aggregates at about the rate prevailing over recent months.

Alternative B

To implement this policy, while taking account of the forthcoming Treasury refunding and of developments in domestic and international financial markets, the Committee seeks to achieve bank reserve and money market conditions that would moderate growth in monetary aggregates over the months ahead.

Alternative C

To implement this policy, while taking account of the

forthcoming Treasury refunding and of developments in domestic and international financial markets, the Committee seeks to

achieve bank reserve and money market conditions that would

slow appreciably the growth in monetary aggregates over the months ahead.

ATTACHMENT E

July 16, 1974

Points for FOMC guidance to Manager

in implimentation of directive Specifications

(As agreed, 7/16/74)

A. Longer-run targets (SAAR):

(third and fourth quarters combined)

B. Short-run operating constraints:

1. Range of tolerance for RPD growth rate (July-August average):

2. Ranges of tolerance for monetary

aggregates (July-August average):

3. Range of tolerance for Federal funds rate (daily average in statement

weeks between meetings):

5-1/4%

6-1/2%

7-1/2%Proxy

8-3/4 to 11-3/4%

2 to 6%

4-1/2 to 7-1/2%

11-1/2 to 13%

4. Federal funds rate to be moved in an

orderly way within range of toleration.

5. Other considerations: account to be taken of forthcoming Treasury refunding

and of developments in domestic and international financial markets.

C. If it appears that the Committee's various operating constraints are

proving to be significantly inconsistent in the period between meetings,

the Manager is promptly to notify the Chairman, who will then promptly

decide whether the situation calls for special Committee action to give

supplementary instructions.